On ACAS in 2009

Some Numbers
ACAS has a debt-to-equity ratio of 1.4:1, and cannot take on new debt other than to repay existing debt. ACAS is permitted to redeploy debt as ACAS is paid, though, according to Malon Wilkus on the latest conference call, and is not obligated to race to retreat its debt-to-equity ratio to 1:1. Although ACAS could theoretically enter new investments with these repayments, ACAS is working to make its creditors happy in the face of its apparent breach of its net asset covenant in its unsecured debt facility.

ACAS holds 4.6B in unencumbered assets, against $2.3B in unsecured debt. Pledged assets are in their own entities and are distinct and separate from the general assets of ACAS.

ACAS has let its lenders see its books, and it does not anticipate acceleration even if it faces interest-rate increases in connection with its debt covenant breach. Default interest ranges from 2% to 3%, which I assume is a spread above non-default interest. ACAS anticipates contesting an acceleration demand, if made, though it didn't elaborate on the legal arguments that might be raised to support non-acceleration (i.e., perhaps that the changes in accounting principles or in the valuation formula inputs were not foreseen by the parties and their subsequent materialization should relieve performance in the same way as would a material mutial mistake).

In 2008, ACAS realized over $2B in exits; the 2009 exits to date were made in the vicinity of prior-quarter valuations. The asset ACAS listed as "worth" $11m under FAS-157 several quarters ago, but which was producing $8m in returns (or 73%) per quarter, was described on the recent call as having continued to produce similar quarterly revenues since ACAS originally described the accounting treatment of the investment. To illustrate this problem in ACAS' investment valuation, ACAS produced a chart on page 11 of its slides accompanying its 4Q2008 conference call. Structured products produced an annualized income of $69m per year for ACAS in 1Q2007 and were valued at $833m; at the close of 4Q2008, ACAS received structured product revenues at an annualized rate of $122m per year, and these were valued at $186m.

In response to a question on the conference call, Malon Wilkus stated ACAS hasn't engaged in discussion of changing to some other form of organization other than the BDC structure. Particularly in light of the IRS ruling that ACAS would be able to issue shares in lieu of cash for a large fraction of its required dividend payments, ACAS may not be in such a cash crunch as previously feared: the amount of cash ACAS will be required to dispense to meet its BDC obligations will not be measured in dollars but in dimes. Assuming ACAS really has adequate interest coverage, ACAS may be able to hold on long enough for the long-term value of ACAS' portfolio to be meaningful.

ACAS has authority to issue about 42m shares below NAV, but management stated that it was very unlikely to issue shares in such a volume simply because at current levels such funding would be too small to bother. ACAS gets much more money than that just collecting interest.

ACAS stated it has approximately 8 portfolio companies for sale in the current quarter, and that last quarter it pulled from sale companies whose bidders appeared to be low-balling in order to take advantage of ACAS in the expectation that it was a highly-motivated seller. ACAS views itself even now as a long-term investor able to withhold companies from the market until market prices make suce transactions favorable.

The big mystery is what ACAS will (or won't) be able to achieve in its negotiations with its unsecured creditors. Obviously ACAS would rather have an agreement in which it is not in breach, but management has made it clear that proposals it has received so far for renegotiation have involved security arrangements that would leave ACAS without the power to say "no" to rotten deals, and could in effect convert it into a forced seller. Thus, ACAS hasn't entered into any currently-offered rearrangement. However, ACAS continues to discuss the situation with its lenders, who are (contrary to some reports) well aware of ACAS' financial situation by virtue of reporting arrangements associated with its unsecured credit line agreements.

ACAS is still getting regular income from portfolio companies and from debt it holds in connection with both existing holdings and holdings it's exited under an arrangement financed by ACAS. ACAS holds debt in various tiers, including high-yield subordinate debt tiers. As ACAS exits companies to become a bond holder, ACAS moves up the balance sheet to a more secured position and trades steady income for the prospect of capital appreciation. Due to the existing credit crisis, this ungraded unsecured debt has a paper value that is in the toilet, even if it is performing. Historically, ACAS has experienced debt portfolios that were not performing and subsequently became performing again, so even the nonperforming loans aren't certainly valueless. Nonperforming loans at ACAS at the end of 4Q2008 were $150m of $5.1B total loans at their then-presently-marked values, or 2.9% of loans by value -- an increase from 2.4% at the end of Q32008. Presumably some of the loss in NAV results from write-downs associated with non-performing debt, which means that the denominator and the numerator in the "bad debt" calculation are both moving targets. It might be nice to have a percentage by face value, but it would be hard to match these face value amounts against the assets shown on ACAS' books simply because ACAS isn't allowed (as a bank is) to show performing loans at face value; it's required to value them as if it would be required to sell them immediately, regardless its intent.

AGNC's dividends continue to flow to ACAS' bottom line, and ACAS has a strong incentive to ensure that AGNC continues to declare as large a dividend as AGNC can afford. ACAS can't raise additional debt, and its share price makes raising funds through equity implausible. ACAS essentially gets to recycle its balance sheet until funds become more available, while looking to de-lever.

The Upshot
ACAS was initially interesting to me because I believed management's ability to cherry-pick good deals in a sea of illiquid and hard-to-value offerings would place it in a position to realize sustainably high returns over the long term. Finding good buys where others don't notice them -- that's what we're all after, right? The recipe for bargains!

The illiquidity of ACAS' portfolio and the difficulty of valuing its portfolio investments has, ironically, resulted in a serious liability: ACAS must both report quarterly on its assets' values and must book unrealized gains and losses on that moving target just as if it had conducted a sale. So in a quarter in which ACAS realized a $0.01 per share loss, ACAS reported losing $8.13 per share. According to its SEC filings, ACAS looks like it's hemmoraging money: in the full year of 2008, ACAS realized $2.58 in earnings (the hard number the tax authorities want to know about) while reporting under the accounting rules governing SEC reports that it lost $15.29 (more than two thirds of which was a result of changes in the valuation formulas, and less than two thirds of which was a result of portfolio performance decline).

The applicable accounting standards seek information about changes in value and not just actual income, and in doing so conflate the two measures (assets and income). As valuation multiples contract (ACAS has gone from having income-to-value multiples of over 10:1 for some kinds of investments to less than 2:1, an over-80% decrease in stated valuation even on consistent revenue), ACAS experiences valuation changes that dwarf income in a given period. Because these unrealized paper losses are hypothesized on the basis of valuation models and are often entirely disconnected from any real-world transactions, it's worth asking in which cases the valuation decline is even relavent to actual value in the hands of ACAS, particularly in the case of assets intended to be held until maturity (e.g., structured products and high-yield subordinate debt ACAS does not generally syndicate).

In short, the very feature of ACAS' investments that made ACAS attractive -- that its investments were hard to value and created an opportunity for a firm specializing in doing due diligence in this segment of the private equity market -- has made ACAS both hard to predict and hard to value. In the absence of a dividend, one can't say "since the money is coming in, it must be working as advertised." We face the fundamental question all over again: does management have expertise enabling it to do better than expected by the market? Is management sound and sober? Those who have been shaken by the dividend cut have left, as have those who view ACAS' performance as reflecting a lack of candor on the part of management.

Who, exactly, is left?

The fact that I can't figure out who's left leaves me with a suspicion that ACAS' share value reflects its loss of its historic owner base rather than a considered view of its future value. In particular, I suspect that it reflects abandonment of ACAS share price to the hands of those who've long assumed ACAS was a house of cards and stands ready to fall at any minute -- and view ACAS' performance over the last several quarters as evidence they are right -- at the very time ACAS' historic owner base has bailed on the ground that ACAS no longer represents a dividend opportunity (especially in light of the IRS ruling enabling equity dividend payments to satisfy REIT/IRC payment obligations) and lacks the high per-share earnings (due to a collapse in asset valuations, not necessarily income) previously associated with ACAS. The bulk of the people in ACAS are just gone -- and so, logically, is the price per share.

The question is simply this: are people missing a deal?

The critics have answered with their feet, and sold -- hence the current share price.