Monday, March 2, 2009

On ACAS' Full-Year 2008

American Capital reported its 4Q2008 results. First the bloody headlines: (a) its asset valuation covenants in its unsecured debt agreements have been blown, (b) its NAV has plummeted to $15.41, and (c) its auditor's opinion, though still unqualified, now bears a going-concern explanatory paragraph; NOI has decreased to $0.21 per share. On the other hand, this 4Q NOI reflects one-time items that lead management to argue that investors consider a $0.41 pro forma quarterly earnings it would have showed but for restructuring charges (e.g., severance packages) and a "deferred tax asset valuation allowance", and ACAS claims a "realizable value" exceeding $20 per share. Which story to believe depends whether ACAS can conduct business as a patient investor or is forced to behave as a panic seller as a result of thinks like blown debt covenants.

Over the quarter, ACAS realized $246m in exit proceeds at exit prices less than 2% different than its prior-quarter valuations. This is good on the one hand -- ACAS isn't acting like a forced seller yet and its valuations are standing up to the test of actual market transactions -- but it calls into question whether ACAS is right that buyers will pay pre-FAS-157 prices for businesses. Conversely, if valuation multiples are collapsing, ACAS' ability to make an exit at last quarter's prices might appear a substantial victory. Hard to read the tea leaves on this. What does puzzle me is why ACAS was willing to exit at a loss, unless it was ejecting dud companies. I'd like to look at this a bit more.

FAS-157 valuations have been hammered by a number of comparables sales that were distress sales, and not arms-length sales by investors agreeing on the value of the sales. Since ACAS values debts owed it at this "market" value (under FAX 157), but must carry debts it owes others at face value (under FAS 159), ACAS shows a value over a billion dollars different than if it'd been able to show both debt held and debt owed under the same accounting treatment.

16% of ACAS' decline in NOI is a result of non-performing loans. This is a problem in which ACAS bears the burden: ACAS entered these loans on purpose to provide income and total return for the benefit of shareholders, and nobody but ACAS is to blame for any inadequate loan performance. ACAS itself underwrote and funded these non-performers. Mind you, this is an especially bad economic time, but I'd like to know if anyone has information about ACAS' eventual performance on non-performing loans during the last downturn (i.e., did ACAS eventually get paid, or did these typically become genuinely worthless on a permanent basis?). ACAS reports a weighted average return on its debt portfolio -- incorporating the nonperforming loans -- at 10.7%. This isn't materially better than Warren Buffet has obtained lately for Berkshire Hathaway by entering transactions with the likes of GE and Goldman Sachs, and Buffett gets potential future equity participation in the bargain; ACAS' debt portfolio is just its debt portfolio.

Like ACAS, ECAS halted its dividend -- something that impacts ACAS' revenues, because ECAS dividends generally flowed right to ACAS' cash pile. This won't resolve until the ECAS transaction closes, at which point ECAS' cash will essentially become ACAS' to play with. The loss of the ECAS dividend was also a hit to ACAS' income and cash flow for the quarter.

ACAS claims that each share is backed with $20.63 in "realizable value", rather more than the $15.41 it is required to report under generally accepted accounting principles as its "net asset value". To the extent that shareholders see an opportunity to buy at about $1 and to get a company that's pulling in hundreds of millions per quarter in cash, this seems fairly interesting indeed. The question is whether the horizon on which ACAS anticipates realizing $20.63 is longer than the horizon for ACAS' solvency in the face of its breached debt covenants and the like.

Slide 32 shows ACAS paying $37m for 9 portfolio companies acquired under distressed conditions. This is the kind of interesting opportunity that I think creates a way forward for ACAS, if it can avoid being squashed. The problem with expecting ACAS to avoid being crushed in a liquidity crisis is that ACAS can't make assurances that its lenders will be happy with ACAS' 2x interest coverage, and won't decide that ACAS' net asset covenant violation are grounds to declare default and accelerate payment of principal. Moreover, default-status interest rates are likely to be materially worse even than the up-negotiated interest rates, and could leave ACAS with scarcely any margin on the loans it's funding with the borrowed money.

The fact that ACAS needs to use borrowed money to maintain its operations is really a problem: Berkshire Hathaway can't do this under in current economic environment against competition with federally-guaranteed banks and make a living at it (even if the banks have crummy balance sheets, the federal guarantee associated with bank holding company status means cheaper access to lent funds), and ACAS hasn't got Berkshire's balance sheet. Of course, Berkshire doesn't have to mark to market holdings like GEICO or its portfolio companies that do things like broker real estate or sell manufactured housing or motor homes. Applying FAS-157 to Berkshire Hathaway would create a definite buy opportunity. Sadly, Berkshire is only down to something like $2450 a share (from over $5,000 in '07, if I recall).

The question I'll have to attack with more brainpower is this: what is ACAS' outlook for avoiding destruction? ACAS' slideshow repeatedly addresses ACAS' status as a patient, long-term investor able to wait for adequate buy offers . . . but in the face of accelerated principal repayment demand, what will protect ACAS from forced sale conditions? I suspect the protection is the very illiquidity of ACAS' assets: a trustee in bankruptcy won't be able to dump shares onto an exchange for the simple reason that there is no exchange on which to dump the assets. The trustee will likely be required to rely on ACAS' expertise to assess the quality of offers, and in the meantime would likely see that ACAS' ability to keep its interest expense covered with current revenues is adequate reason not to kill the income-producing assets in a fire sale. (This assumes creditors bring an involuntary bankruptcy in order to cause asset sales to fulfill their demand for accelerated payment. I have some doubts that ACAS would deliberately seek bankruptcy, though I can imagine some advantages in terms of avoiding harassment by unsecured creditors. On the other hand, ACAS pointed out that its unsecured creditors have no power to foreclose on ACAS portfolio assets. Also, a couple billion of ACAS debt is non-recourse debt backed by investment products and cannot result in action against ACAS for payment; only $2.3B form the debt backed by the breached net asset covenants.)

More later.

At present, (a) the interest coverage appears attractive, (b) the fire-sale opportunities are exciting, but (c) the fact that the debt covenants have been breached put ACAS into wild territory where the map no longer shows the roads. The IRS has made a temporary ruling that BDCs can satisfy their dividend-payment obligations in part (up to 90%) with stock dividends, which would enable ACAS if needed to preserve capital. Malon Wilkus stressed that ACAS' intention is not to scour the markets for distress entry opportunities, but to get out of trouble with creditors and thus to preserve capital. Moreover, he pointed out repeatedly that ACAS' employees are all shareholders and that management is strongly aligned with shareholders in having both significant holdings and large and deeply-underwater options rights that motivate them to restore share value to ACAS.

Malon Wilkus stated that ACAS remained committed to creating long-term value. This of course is good news, but leaves open the question whether ACAS has the financial strength to continue acting as a long-term investor able to avoid forced-sale situations.


Imperator said...

I got the sense from the slides and the discussion that the covenant breach (on unsecured debt) wasn't THAT big of a deal. If they do not accelerate the repayment, the default interest penalty is only 2%+ . Any idea of what the exact covenant was? I'm guessing it is some sort of debt to equity level requirement that the mark-to-market destroyed.

However, the stock is trading near $1, and seems to be hellbent to zero. If they are still generating cash, servicing the debt, and having a NAV in the teens, how is the stock trading as worth the equity is worthless?

If it isn't worthless, any thoughts on selling puts at the $2.50 strike?

Rob M said...

Thanks for the analysis. Sobering and well..... this is a bit of a bother, isn't it?

Jaded Consumer said...

I started buying at $40+. I'm not selling at present, on the theory that after falling 39 of 40 floors I'm not likely to be hurt much worse for the extra ten feet if the cushion is really going to fail: I'd rather take a chance on the cushion than eat the certainty of hitting a raised platform at the top of the first floor to save ten feet.

Also, I genuinely believe ACAS' management has its head on straight, and will continue to perform as far as ACAS can be made to perform. This isn't a case like some of the high-profile accounting scandals in which the problem was some fool cooking the books to bake himself a nice quarterly bonus. This is a case in which the company was making good money and got caught leveraged during a credit panic.

The exact same thing happened to me in my personal portfolio, and it hurt awfully.

As for naked puts at $2.50, I've lost enough on short-dated naked puts, thank you. If the time horizon were years instead of months, I'd like the bet a lot more. However, I can't negotiate 15- and 19-year option positions like Warren Buffett. I'm stuck with the short-dated standard options and I've learned from rough experience that you can't just roll these things out forever until the storm blows over, because (a) the strike prices that remain available are not guaranteed, (b) the margin requirements needed to keep them going are potentially chaotic and can rise dramatically overnight during a panic, and (c) there's just not enough money in it for my risk unless one created hedges that suck most of the profit out of the transaction. So no, I'll not be creating short put positions soon.

I do expect to continue watching ACAS' NOI to see if ACAS can maintain the income needed to keep afloat. The dividend ACAS is expecting to pay later this year is about the size of ACAS' current share price, you realize. This suggests the market is expecting ACAS to fail. The question here is whether one can learn enough about ACAS and its business relationships and portfolio performance to ascertain that ACAS will not fail despite the debt covenant breach, the continuing depression, and the contraction of earnings multiples.

In the last conference call, Malon Wilkus made a big point of repeating that ACAS is a patient investor. Let's face it: last year, so was I, but I was crushed with a liquidity crisis and ended up a forced seller, my best intentions and expectations aside. The question is whether ACAS will do better.

As previously mentioned, though, ACAS' borrowings are not the equivalent of a margin account. ACAS may be in a much better position than a retail investor to handle curve-balls in this regard. Over the next couple of weeks, I'll be looking for evidence on ACAS' long-term strength or at least current survivability, and I expect to make some decisions then.

Anonymous said...

Dear Jaded,

I couldn't wait to see your take on all of this - good or bad. I am also in at a high pps (35th floor) but have also bought more on the way down from those nice people selling their shares out the window, especially around the 10th and 2nd floors. Now, I wait. I hope that the few of us who comment are likely a tiny fraction of those who read your column here value it highly. We know it's a sideline for you; but implore you to keep at it for our sake! Thanks.

timberwolf said...

The question was raised as to why take actual losses against reserves if the portfolio is so solid. One reason is to avoid paying a dividend and thus conserving cash. I note the NOI and the loss on sales is the same.

Jaded Consumer said...

FAS-157 requires ACAS to value its illiquid portfolio on the basis of economic models driven by inputs like the yields on bonds thought to be comparable to ACAS-held debt, and the sales of companies thought to be comparable to ACAS portfolio companies. During the current panic, many of the comparables' sales are distress sales and create unrealistically low output values for modeled values for assets ACAS intends holding for current business performance, or until some natural maturity.

ACAS can't simply decide that since an asset is solid, it should not be marked down. ACAS is bound to employ accounting standards required to be applied to every similarly-situated publicly-traded entity.

To illustrate ACAS' frustration with FAS-157, management several quarters ago lamented that the accounting standards required it to value as "worth" $11m a debt asset that produced -- and to through the current quarter has continued to produce -- $8m per quarter. Read that again: it produces $8m per quarter but must be carried at an asset value of only $11m.

This kind of "valuation" is a factor I'll be thinking about when I decide what to do with my own ACAS holdings.

Also: less than a third of the unrealized losses booked by ACAS result from asset performance degradation; most is the result of changing valuation model factors like marketplace multiples contraction, worsening comparables sales, and harsh pricing under bond-yield analysis.

Interesting, no?

timberwolf said...

The CEO stated that the current mark to market system (fas157) is marking to the liquidity of markets rather than the credit worthiness of an asset. When the spread between the bid and ask price is wide I think he is right.

Anonymous said...


Can't believe how well you explain things! It saves me a lot of headaches. I was panicing. Your posting help ease it. Please keep us posted.