Saturday, January 3, 2009

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.


Edgar said...

Thanks for shring your thoughts on ACAS. I hope you averaged down over the past month or so. While I sold my ACAS holdings after the suspension of the dividend--at a loss, I'm afraid--your analyses helped me maintain faith in the intrinsic value of ACAS. I bought back in yesterday at $4.07, and have now nearly recouped all my 2008 ACAS losses in two days.

Thanks again for a blog that is both well-written and insightful.

Anonymous said...

Do you have any opinion on the [possible success or failure] of attempts at class action lawsuits aimed at ACAS?

rktoledo said...

Why doesn't ACAS sell their AGNC shares for $150mil to obtain some quick liquidity. I would prefer this step first over a sub-NAV dilution. ACAS also mentions in the filing that they are in different stages of asset sales. Why not complete some of these asset sales by lowering the sales price. It seems the loss to NAV from selling these assets on the cheap would be better than huge dilution from a sub-NAV offering. I also read in filing that ECAS & ACAS can not declare a dividend until acquisition is compeleted (mention of being able to declare dividend before merge but payments need equated to all parties after the merge seems very complicated to do). I thought that bit of information was interesting. Thanks for your continuining thoughts on ACAS. Very good stuff.

Jaded Consumer said...

I don't have an opinion on the merits of the suit because I have not read it. The possibility that someone has a legal theory that might hold up under some set of facts that might be provable through discovery procedures, even if remote, will keep the litigation alive long enough to create expense and distraction.

On the other hand, the claim that ACAS should have done something different with its dividend or the like, because the litigants can show an economic benefit from a different decision, reminds me strongly of a case I recall hearing about involving American Express. There's some discussion of Kamin v. American Express at Prof. Palmiter's site at Wake Forest. The argument in the case is that AmEx should have sold shares of DLJ at a loss, realizing an $8million tax benefit, rather than issuing the shares as a dividend to shareholders who could not realize the tax loss because they did not enjoy AmEx' high basis. There was no economic benefit to the company at all in issuing the shares as a dividend, and a demonstrable harm. The result? Management was free to issue the dividend because of confidence-related and marketing advantages in not being perceived as having experienced a big capital loss on an investment. Window-dressing was a widely-understood strategy for making companies look good, and AmEx' board was entitled to avail itself of the practice because they could articulate some rational basis for thinking it a reasonable decision. The fact anyone with a calculator could prove the economic detriment just didn't matter. This rule, called the Business Judgment Rule, is designed to protect managers' decisions from Monday-morning quarterbacking by even people with really good arguments. It's akin to the immunity offered legislators: if you don't like the BS they push, vote 'em out, don't make the courts figure out what they ought to have done.

I don't particularly think carrying the Business Judgment Rule to that extreme is necessarily a good idea, but assuming the Rule is still good law, trying to get a court to second-guess dividend decisions on the theory management should have been more wary about future liquidity concerns just don't strike me as particularly appealing.

Let me remind you, though, that I haven't read the current litigation and don't intend to give any opinion on it in particular. I just have a general skepticism of this kind of suit in the face of the BJR. To win, I would think a plaintiff would be in a much stronger position showing self-interested transactions, intent to steal for personal gain, and/or intentional but concealed violation of established accounting principles. Think Enron or Worldcom or the like.

The argument that "they should have been more fearful" is the kind of thing I expect the BJR will cause a court to dismiss for failure to state a claim on which the court could grant relief.

Jaded Consumer said...

Oh, on Kamin v. American Express: here's a link to the case.

Jaded Consumer said...


ACAS doesn't want to sell AGNC because ACAS believes it can create more value there. ACAS doesn't want to flip its assets, it wants to create stable and growing portfolio income. AGNC produces nice monthly income -- cash -- and a big quarterly dividend. AGNC at present provides ACAS a quarterly cash payment (dividends plus management fees) of 4¢ per ACAS share. Selling the shares would leave ACAS with only the management fee, and would leave potential investors in AGNC concerned that ACAS doesn't have skin in the AGNC game. ACAS' plan to grow AGNC is surely dependent on widespread confidence in its incentive to properly manage AGNC for the benefit of shareholders, and being AGNC's largest shareholder definitely supports that conviction.

My question is whether AGNC, which trades above NAV, can raise capital with new issuances, thereby enabling ACAS to grow its managed funds and thus its fund-management income. At some point, ACAS' funds management business should become material. At present, ACAS' income derives primarily from portfolio performance.

Let me make a little comment on ACAS' NOI. NOI isn't necessarily all cash. You can have an accounting profit without having positive cash. I don't happen to know exactly how much cash portfolio companies provide, and to what extent ACAS can really tap those amounts, but all the dividends and management fees resulting from AGNC are cash, making it especially valuable and worth holding onto like a lifeline.

Anonymous said...

Your commentary has been fantastic. I've been a huge ACAS fan and gathered up shares at times of skepticism and it's always paid off. I bought a bunch more at $10 a couple of months ago and I felt like I had really scored until it looked like they might breach the net worth covenant. Then I must admit I was truly worried they might go under and they might. But when it hit $3 I was ready to buy a bunch more, but of course I got distracted by the holidays and now I'm kicking myself silly. It's such strange times that such a well run company is at such risk because of a bunch of stupid accounting rules and general fear in the rest of the market, which in the case of most other companies is well founded. I kind of feel like George Bailey in it's a wonderful life. If ACAS (and us share holders) survive the "run on the bank", they'll be fantastically positioned for a great run up in price.

Nivdung said...

I was considering buying when the stock looked cheap on valuation measures like P/NAV etc. Here is why I did not invest. Let me be also clear that I would also like to invest for the long term i.e. forever if possible. If you look at the source of equity for ACAS, most of it comes from share issuance and if you examine equity over a number of years it can be proven that ACAS used the famous startergy "WB" has warned against - taking money from "Jane" and giving it to "John" for a number of years and last few years more seems to be coming from earnings that Jane-to-John. Also ACAS is more like an REIT which has to payout 90% of what it earns and the remaining 10% is not enough to finance its portfolio companies so it has to go to the "Jane" time and again. Its not a good proposition. For a long term investor - today when I want to invest, the dividend for last 10 years is history and is worth nothing, and the next dividends which will come from what the underlying business will earn has more meaning. But only 10% has been retained and most years what has been paid came from "Jane". So your investment thesis as ACAS as a long term investment is flawed. However I must agree that if you stay in it for 2-3, you are likely to profit. But not from a sound investment thesis but from the speculative aspects. So the question becomes just because you profit on the price (1-day, 2-3 years), does it make a favorable long term investment in terms of investment in a value producing underlying business ?