ACAS: 3Q2008 Report

In the quarterly announcement, ACAS' management explicitly addressed the liquidity threat created by the tangible asset value in its recently-renewed debt agreement.

Performance for the quarter
Net Asset Value at close of quarter was $24.43, down from $27.01 at the close of the second quarter; the reduction is driven chiefly by FAS-157 writedowns of unrealized depreciation resulting from multiples compressions as the worldwide markets' pricing decreases, the drop in price of shares of publicly-traded companies to which portfolio companies are compared, and the effect of changing interest rates on valuations generated with bond-yield-analysis techniques. Because ACAS is not a bank and is not permitted to carry performing loans at face value, but must re-value fully-performing loans on the basis of market factors that are beyond ACAS' control or that of its paying obligors, the risk remains that these wrote-downs will continue evan as portfolio income remains strong and debt obligations continue to be paid.

Net Operating Income -- a number that will be more important going forward due to announced changes in dividend policy -- increased sequentially from $0.71 to $0.74 per share, though it was down from $.81 in the year-ago quarter. It's worth noting that in 2007, ACAS' operating income involved a rather

Pretax Earnings were $0.98 compared to a projected $1.05 for the quarter; however, because ACAS elected to retain capital gains and was obliged to pay on behalf of shareholders the taxes on the "deemed dividend" represented by this retained amount, the earnings involve a tax charge, reducing the earnings to $0.72. Even the $0.98 is below estimate, though: ACAS expected to close deals that didn't close, and missed out on some realizations as a consequence.

Shareholders of record on September 30, 2008 are entitled to a $0.25/share tax credit (this means when one files an individual Form 1040 for 2008, one is entitled to claim having already paid $0.25/share in taxes above whatever else was paid or withheld for the 2008 tax year), and also to adjust their basis upward $0.49 per share (which only helps at exit). This is a result of retaining long-term capital gains that would have been payable under the prior dividend policy.

Realized Earnings -- the number that drives ACAS' BDC-related dividend-paying requirement -- were $0.72 for the quarter after taxes associated with the deemed dividend and other items.

GAAP Earnings -- the SEC-reported "earnings" that reflect mark-to-market price changes as if they were realized -- were negative to the tune of $2.63, giving rise to the NAV decline of $2.58 to $24.43. Due to ACAS' changed dividend policy, dividends will be driven by NOI rather than net taxable income, and will still bear no definite relation to the "earnings" reportable under GAAP. The GAAP earnings will be as crazily out of whack with dividend-paying capacity later on, when multiples expand and asset values explode beyond actual earnings.

Although ACAS' management claims that its net realizable value is hundreds of millions of dollars above GAAP values, the utility of this measurement seems slight in light of the fact that it represents neither ACAS' current liquidation value for the assets, or ACAS' expected actual return on exit. (The number sounds like that, but when faced with a question last quarter about the losses baked into the non-GAAP valuations given, management said it didn't expect to realize those losses, either, and that it expected the future to hold, in fact, some other undisclosed return.) The non-GAAP numbers are thus not so much a beacon illuminating the coast as yet another siren amidst the rocks, offering only puzzlement.

ACAS' portfolio company exits were within 1% of the prior quarter's valuations. The thesis that ACAS' management is lying about valuations seems further weakened by actual sales performance. This doesn't mean there's not a case to be made against ACAS, but it's not based on malfeasance by management in stating portfolio company valuations. The best thesis against ACAS is the thesis against any financial: the economy is heading into the crapper.

Management believes the company is operating amidst in a severe recession and is conducting itself accordingly, including by de-levering. Valuation drops pushed ACAS' debt:equity ratio back to 0.9:1, and management is working to reduce it again.

ACAS is addressing the liquidity threat with several initiatives
In a return to its older dividend policy, ACAS will retain capital gains (and pay taxes on them) rather than pay this portion of earnings to shareholders. ACAS needs the money to cushion its asset value's distance from bare-minimum debt-covenant levels. Future dividends will be driven by operating income, not capital gains. This dividend policy is far more apt to result in steadily-increasing long-term returns than a policy in which all gains are distributed, preventing increases in invested capital. Interestingly, the incentive of ACAS was reversed when shares ordinarily traded materially above NAV. Under the DRIP at prices well over NAV, ACAS kept more money by keeping pretax capital gains and issuing shares than it did by retaining post-tax capital gains and then reinvesting only operating income pretax. The policy of paying all earnings was sustainable only to the extent that above-NAV share pricing remained the normal state of affairs. In the last year, above-NAV trading has gone from uncertain and unpredictible (between the announcement of a share-buyback program in January due to the below-NAV share prices, and the next trade above NAV, was sixty-one days) to doubtful (ACAS has continuously traded below NAV for months).

Rather than announce in advance a schedule of dividends and stick to it, ACAS has announced that its board will set quarterly dividends after each quarter, based on quarterly results. Consequently, the pre-announced $1.10 dividend projected to be paid for the fourth quarter of 2008 will not be declared as predicted; any dividend to be paid on the fourth quarter of the year will have to be set after the quarter is over. Given management's repeated discussion of protecting capital, I would not expect to see a dividend from ACAS regardless its quarterly performance for some time. The benefit of longer dividend retention is lowered cost of cash: ACAS is borrowing it interest-free until earnings turn into declared dividends. When ACAS' shares traded above NAV, dividends didn't result in loss of liquidity, but in the issuance of shares above NAV. With a share price below NAV, cash dividends sap investable equity and threaten liquidity and drive the company toward the minimum tangible asset levels established in its debt covenants. Do not expect to see ACAS with a pre-annouced all-income dividend again; the procedure of having the Board set dividends following each quarter will place ACAS in the best possible position to game the dividend game on the basis of share price, market conditions, and tangible net asset value. The new policy is wiser and more fiscally conservative in addition to being more flexible.

The ECAS Transaction
Assuming all the necessary approvals are reached, asset volatility attributable to share volatility in ECAS -- whose below-net-asset-value price of its publicly-traded shares has given rise to terrible volatility in ACAS' portfolio value -- will be subdued in a financial engineering exercise in which ACAS will purchase ECAS' outstanding shares in an all-stock (1 ACAS share will buy three ECAS shares) transaction; the result will be the destruction of the NAV discount in ECAS and the increase in ACAS ownership of ECAS, which will mean an increase of about $1.25 per share in NAV for ACAS (and presumably the elimination of expenses related to ECAS' publicly-traded status). The 11.5 million ACAS shares issued in this transaction would bring ACAS' outstanding shares to 218.5 million shares, meaning that the anticipated $300 million in net operating earnings being rolled from 2008 into 2009 for payment of dividends would be about $1.37 in operating income ACAS would be required to declare by the end of June for payment by September 30, 2009.

Tax Status
ACAS addressed a question about its tax status with a long exposition about the fact that BDC status had been good for a long time, and that many investment forms (banks, BDCs, REITs, C-Corps like F, government-chartered entities like FRE, you name it) had suffered during the quarter, and that careful thought would need to go into long-term decisions on issues raised by the last forty or so days. It became clear that abandoning BDC status in favor of treatment as a bank or investment holding company or some other form of investment was not being clearly taken off the table as an option, and that management would continue to evaluate all the options available when deciding how to protect shareholder value in light of developing conditions.

Conclusion
ACAS' share price (under $8 as I write) is less than a third of its NAV. ACAS continues to enjoy liquidity from investment exits, its debt portfolio is performing extremely well for an economic catastrophe such as that we see now (nonperforming loans are less than 3% of marked values), and its net operating income appears strong. The 2008 profits rolled forward into 2009 must -- in order to avoid threatening ACAS' status as a regulated investment company -- be declared as a dividend by the end of June 2009 and paid by September 30, 2009; these appear to be approximately $1.37 per share. Assuming ACAS paid no other dividend in 2008 besides this minimum regulatory requirement (if ACAS retains its RIC status, 2009 profits would face a similar distribution requirement but with dates in 2010), ACAS would still have a double-digit dividend yield in 2009. ACAS' plan to use returning profits to reduce debt will protect ACAS from liquidity emergencies, ensuring that ACAS isn't placed in a "forced sale" position that would destroy the investments ACAS has made, and obliterate the prospect of participating in these companies' return to performance as the economy improves. The slowdown in exits -- and I believe there has been a slowdown in exits, as evidenced by the deal closings that didn't occur, no doubt related to the contraction in liquidity on the part of buyers -- makes ACAS' strong NOI that much more attractive. (ACAS has deliberately invested in counter-cyclical portfolio companies as the recession approached, and NOI continues to look good even though it is dwarfed by FAS-157-related writedowns that haven't been realized as losses and may well never be realized as losses.) As a long-term investment, ACAS at about a third of NAV and in light of its steady NOI seems a solid holding.

Management seemed to warn of expected future FAS-157 writedowns as the economy continues in recession. It's possible that ACAS will consider steps such as abandoning its BDC status and becoming an entity whose accounting enables it to value its assets differently, in order to avoid liquidity pressure caused solely by accounting issues and not by investment performance. (Becoming a bank, for example, would allow ACAS to carry performing loans at face value rather than at a value modeled on the basis of bond yield analysis; being treated as an ordinary C-Corp would enable ACAS to retain earnings like most corporations, and support its value with earnings accretions; and so on.) ACAS is battening down the hatches for a financial storm, and as usual is willing to upset analysts in the current quarter in order to protect long-term interests.

Summary:
Management takes a dim view of the current economic environment and its future, but is impressed by continued performance of portfolio companies, including some selected for being acyclical or countercyclical. Credit market issues will likely cause further FAS-157 writedowns in irs debt portfolio -- not because of credit or performance issues, but because bond yield analysis will drive down current holdings' values as credit becomes less available (more costly) to current credit seekers in a worsening economic market. ACAS cannot be treated as a dividend stock until further notice. At one less than one third its NAV, and with new access to earnings for reinvestment and for de-leverage, ACAS' shares represent an opportunity to make a value play at a diversified portfolio of well-managed middle-market companies that are still making good money in a crummy market, and allows participation in a diverse debt portfolio.

In the short run, more scares lie ahead. In the short run, multiples compression and debt-revaluation on the basis of bond yield analysis will continue to threaten equity levels, requiring earnings retension and forcing debt retirement. Expects shorts to return in droves, no longer fearful of having to cover ACAS' dividend as they bet on a financial meltdown at ACAS. In the long run, this company will do extremely well on investments made at a bargain and as holdings are re-valued in economic environments that support higher P/E multiples.