Issuing More ACAS?

While I was traveling for the holidays, I got this comment from babycondor asking what I thought about ACAS' solicitation of shareholder proxies to approve issuing new ACAS shares below NAV. (The "and transact other business" language doesn't strike me as alarmingly as it might strike some, as it smacks of ordinary boilerplate. The real question is whether you think management is unworthy of confidence, in which case you must sell regardless the seeming merits of the current proposals.)

In the past, I've scoffed at folks who said ACAS' share issuance harmed shareholders by diluting their value, because ACAS' management is limited to issuing shares above the net asset value of the pre-issuance shares. Thus, shareholders always ended up with more value per share just after the issuance. (That is, unless you ascribe to the "all the good deals are gone" theory, in which case the old deals are more valuable than the new cash that exceeds their paper value; I just don't think all the good deals are gone, and ACAS' 10-year track record of NOI and -- until this quarter -- increasing dividends seems to bear this out).

As described previously, ACAS is trying to navigate a serious liquidity crisis. The extra color we got in the post-quarter Merrill Lynch Q&A hasn't made the crisis disappear. There's also a considerable range of viewpoint on whether ACAS' management continues to deserve credit for diligent work on behalf of shareholders. The history of posts on this shows, for example, that I view ACAS' management as pursuing reasonable efforts to address a serious ship-on-fire/sinking-hotel armageddon in progress, whereas the Enlightened American views management as having exposed itself as unworthy. Note that both blog writers had exposure to short puts :-( (see the comment following mine on his blog). It's not like either of us has enjoyed the current implosion.

The Enlightened American concluded his last comment on this topic with a challenge: "Care to put odds on the likelihood of forced selling or worse?" And I'm here to tell you that the odds of an event like that has now reached unity: management is trying to sell shares below NAV, which is guarantees to dilute the value built up in the shares. That is, there is a 100% chance that following a below-NAV share issuance (and ignoring for a moment any financial miracles that might be achieved with the cash) the NAV and NOI per share will decrease.

Or ... is that chance actually 100% of increase?

The secret lies in the ACAS/ECAS transaction (described here; ACAS by taking ECAS private will change how its value is booked, creating instant improvement in reported book while acquiring NAV and NOI below ECAS' booked value due to its continuously-depressed trading price). This is an all-stock deal, but the stock ACAS is getting in the deal has a market value -- which is less than the NAV of ACAS (but, like ACAS, is depressed).

So far, so good. I liked the transaction before, and a vote to permit this is a step in the right direction. The next question is whether the permission to issue shares below NAV, not being clearly limited to shares needed for issuance to close the ECAS deal, is rational for shareholders. This part should alarm the thoughtful reader.

The really funny thing is, this actually makes sense. In the proxy statement, ACAS explains how ECAS' credit has been renewed only on really nasty and increasingly onerous terms, and ECAS like ACAS needs to lend money to portfolio companies (at a spread) to make money. ACAS itself has seen its borrowing rates worsen, cutting into its margins on loans even as its net worth is hammered by valuation rules to the point its net worth covenants threaten to obliterate its lines of credit. Thus, servicing ECAS (and ACAS) investment lending obligations without getting stuck with nasty terms could torpedo either the deal (because owning shares of an ACAS that is about to implode in a liquidity crisis would seem a bad deal to ECAS shareholders, who will balk) or the future of the combined entity is a factor seriously impacting the ECAS transaction and desperately driving ACAS to find cash -- anyplace. ACAS' net worth covenants are much easier to satisfy if it has cheap capital (from you, of course, not from the greedy banks!) to further de-lever ACAS and to increase its net worth.

Is this a good deal for existing shareholders?
This is where the money is: this is the question that people like me -- who actually hold these shares, and for whom this isn't an academic exercise -- need answered in order to know what to do as this meeting approaches. The easy answer -- that all ACAS' issuances have been accretive, and that there's no dilution -- simply no longer applies.

The only applicable security against insane pricing is an issuance condition (spelled out in the proxy materials) that prevents below-trading price issuance. When ACAS traded above NAV, issuing below trading price was no big deal: shareholders still had more equity per share after the deal closed, so ... no harm, no foul -- right? Now that ACAS is trading at such a steep discount to its NAV, and nobody will pony up above-NAV cash for the shares, ACAS is looking at an alien landscape in which the rules of navigation require a lot more thought.

Is there a case in which below-NAV issuance could benefit shareholders?

There are only two cases here. If not, one must vote no. If so, one must know whether those conditions exist. To examine the possibility of the second case, let's have a look at what the alternatives are and what benefits -- other than immediate-term NAV changes, which will be in the wrong direction -- might accrue.

If ACAS doesn't have cash, can't revive ECAS lines of credit on commercially useful terms, and sees its own valuation squashed to the point its own credit disappears (due to net worth covenants that are breached as bond-yield analysis and comparables analysis make even properly-performing ACAS investments seem nearly worthless), then the place to look for a bargain in ACAS will be in the court hearing ACAS' bankruptcy proceedings. If ACAS' net worth drops below the magic threshold (or ACAS changes from being a BDC to change its accounting rules, something also disclosed in the proxy statement), the unsecured creditors will be in line ahead of common shareholders and will seek liquidation of whatever ACAS owns to pay back amounts borrowed under the line of credit. I'm assuming here that ACAS hasn't got more than a quarter to make its books look good to creditors in the event it has a probem meeting the net worth covenant, and can't magically solve its problems with financial re-engineering. Moreover, I assume that the large investors in which ECAS shares are concentrated are aware of ACAS' financial condition as a result of due diligence activities, and won't help until it's clear ACAS is going to survive the quarter without imploding with a liquidity crisis.

Since ACAS' deleveraging efforts have reduced ACAS' debt to the point ACAS is still in the vicinity of 1:1 leverage despite its valuation problems, there is some theoretical possibility that after liquidating ACAS' assets there will be some non-zero value in ACAS and that ACAS could continue to collect, e.g., a management fee for externally-managed funds like AGNC, which is trading above NAV on the investment acumen of ACAS' managers (and in light of its easier-to-value government-backed assets). However, these activities are likely to produce modest income. For example, AGNC yields ACAS something like 4¢/share, but most of that is a result of dividends paid to ACAS as a shareholder. Those shares should be expected to be liquidated in bankruptcy to raise cash, leaving ACAS with something like a half-penny a quarter in management fees on the investment. Compared to the >70¢ a share we've seen from ACAS lately, this isn't much different from zero.

In short, the illiquidity case looks pretty grim.

What would ACAS do with cash raised while diluting your shares?
One answer is to retire debt. Lowering interest expense and decreasing liabilities to pump up net worth will protect ACAS from the dangers associated with the vaporization of its existing lines of credit. This in and of itself has a certain value, in that it is insurance against the company's dissolution. If one views the existing investments as dramatically undervalued, and expects them to perform well and continue to create income and worth, then accepting some dilution to prevent their loss in a bankruptcy proceeding brought on by a liquidity crisis triggered by the calling of substantially all of ACAS' unsecured credit may make sense.

I haven't seen whether there are any limits on ACAS' issuance -- a certain amount of money, a certain number of shares, or what have you -- so I think ACAS would continue to cruise about looking for opportunities to invest. I do not think ACAS plans just doing the ECAS deal. I think assuming that in the absence of clear limiting language is naïve.

Given the investment opportunities presented by distress among market participants -- ACAS' quarterly valuation efforts surely give it a special point of view on these opportunities, making it an especially sophisticated examiner of this kind of investment -- it's possible that management is right in thinking that money invested at these levels will be worth significantly more when markets behave normally again in a few years. The point of view we need to look at here -- as we trade around $3 -- isn't whether we'll quickly see $45 again after dilutive issuance, but whether we can protect so successfully against risks that would drive the shares to $0.05 that we see $15 again in a plausibly-rapid time frame.

The need to create liquidity is real. The future of the enterprise depends on increasing tangible net worth, which is the key to avoiding having ACAS' loans called and thus becoming insolvent. Wilkus made a comment about going to zero leverage, but I doubt that will materialize: the deals are just too good for a savvy due diligence team in an ocean of distressed sale opportunities. So long as ACAS can avoid becoming one of those distressed sale opportunities, this is a great time to be in the business of doing the deals on which ACAS has built its business.

ACAS' proxy material contains language touting the great buys out there, and you can bank on ACAS wanting to buy, buy, buy all the good stuff that folks on hard times are forcd to dump in an illiquid market. I think $1 in cash in this market is arguably worth quite a bit more -- in purchasing power -- than $1 in a liquid market with higher multiples. I think the future income streams ACAS can acquire with current liquidity can, with careful management, make current shareholders happy they stuck with it. WARNING: this is the view from the bottom. Looking down to here from $48 and asking when the bus will return is another question entirely. But as viewed from the bottom, this is a very positive position.

Bottom Line
The upshot is that if you don't trust ACAS' management, you need to flee -- now. If you think they have their stuff together, then entrusting them to keep it afloat makes enormous sense. I think ACAS will turn out to have been a great bargain at $3, and I'm not jumping ship just when the buying opportunities -- that is, the future returns -- look most attractive. I still believe (and the performance of ACAS-managed funds like AGNC bear this out) that ACAS' sharp folks can quickly adjust to strange times and find the opportunities lying therein. I want to be there when they prove me right.