At American Capital Ltd.'s investor relations page, one can get the Q42009 presentation PDF and a link to what will eventually be a rebroadcast of the earnings call.
ACAS: Cure Worse Than The Disease?
Slide 14 is interesting, as it offers some balm for the fear that ACAS is liquidating its valuable investments to raise cash to feed hungry creditors. The fear is, in short, that to avoid forced liquidation ACAS has been selling the best of its portfolio just to keep the lights on, and there will be nothing worth owning after. Enter Slide 14. Of ACAS' $1.1B in 2009 realizations, $820M was received in the form of principal payments on debt owed ACAS and the sale of loans made by ACAS. Only $323M of the 2009 realizations reflect the sale of equity. (In Q4, exits of $476M included $57M from equity and $419M from principal/debt.) This has two sides, of course; if the equity is valued low, the exit of equity may not result in much cash even though ACAS does, in fact, liquidate equity. Hence, the $716M in net portfolio realized losses reflected on slide 14. Slide 14 does offer some more balm to fears ACAS is liquidating the crown jewels out of desperation: the exits consisted of $122M in gross realized gains and $838M in gross realized losses. ACAS isn't just selling the winners, it's selling a lot of losers. Considering that these big numbers reflect the post-loss prices, the losers vastly exceed winners.
What's this mean for the future? ACAS' requirement to distribute a dividend is based on ACAS' taxable gains. The reason ACAS doesn't pay taxes itself is that as a BDC, ACAS is required to distribute taxable gains to investors, who are taxed on these amounts. If ACAS realizes losses – by selling investments that won't result in much profit and by letting losers get bought – ACAS can avoid having to pay cash dividends. ACAS may be setting itself up for a couple of years in which it need not pay any dividend at all. As ACAS accrues losses, ACAS' ability to reinvest without worry about liquidity issues brought on by dividend-paying requirements will improve.
ACAS' portfolio remains diverse by industry (see Slide 45). If ACAS is indeed keeping the best investments for long-term gain, or even positioning itself for the particular economic cycle before it, ACAS could be trying to build a financial position from which to maximize the impact of the eventual economic recovery. An example of the future performance is illustrated by ACAS' investment in European Capital. At the close of 2009, ACAS' equity investment in ECAS had a FAS-157-compliant "Fair value" of $243M, but a NAV of $0.7B. The discount to NAV is based on (a) the status of credit facilities (e.g., ACAS' default of net-asset covenants and at least theoretical risk of fire sale), and (b) the NAV discount of publicly-traded funds thought to be "comparable" to ECAS. Although the short term marketplace is a voting machine, the long-term offers a weighing machine, and if ACAS keeps jewels like ECAS it's in a position to do much better than current NAV would suggest. ECAS, because it is discounted to NAV before entering ACAS' NAV, is available to shareholders at a double-discount. This is because the roughly 50% discount to NAV that ACAS has lately offered has allowed investors to buy for about $125M a portfolio ACAS carries at a $243M "fair value" but has a NAV of $0.7B. To the extent of ACAS' ECAS holdings, shareholders buy it at about 1/6 of NAV. What's crazier? This is after ECAS experienced a $124M Q42009 appreciation in "fair value" (see slide 36).
Given that ACAS' market capitalization has recently been in the range of $1.25,B, the fact that one ACAS holding suggests an undervaluation of nearly $500M should make one think about the remainder of the portfolio. Given that ACAS has historically traded at a premium to NAV, the mispricing of ACAS' holdings suggests good things to the patient investor.
No Big Discount?
A criticism of ACAS has been doubt that ACAS' portfolio investments could be sold for their claimed values. Yet, among my original investment theses in American Capital was that the illiquidity and opacity of small investments made by ACAS created opportunities for mispricing, leading to potentially outsized deals. Slide 16 shows that ACS has averaged almost exactly the claimed "fair value" on investment exits, with quarterly overall exist within a percent or two of "fair value" since the beginning of the economic crisis. Slide 16 makes clear that, at the moment, ACAS isn't able to sell holdings at a better price than recognized by FAS 157, but has not been forced to accept lower values, either. Thus, ACAS isn't a get-rich-quick scheme. It's a wait-for-rational-pricing scheme. It's a value-investing thesis.
In the short run, however, Investors' best bet is that ACAS can find purchases that are mispriced. Because the exit pricing doesn't seem particularly exciting, the profit has to be made by entering the deals cheaply. Toward this end, ACAS has a "special situations group" whose whole purpose is to find opportunities (like the New England Confectionery Company, whose candy business and real estate holdings appeared much more valuable separated) for below-value investment. In a market characterized by distress, one might expect ACAS to be running around buying underpriced distress opportunities left and right. Unfortunately, this hasn't materialized as I'd hoped before now because ACAS has itself been distressed. However, Slide 41 shows that ACAS has bought a couple of new distressed portfolio companies – the majority of its Q4 investment – while making add-on investment for 4 existing portfolio companies (including funding one portfolio company's acquisition). In 2009, ACAS bought 18 distressed companies for $81M. (Slide 42) If these companies were as mispriced as ECAS before the end of the fourth quarter, investors could be in for a treat.
Once ACAS has a deal with its creditors that alleviates the (misplaced, I believe; see Slide 26 and the continued ~2x interest coverage) fear that ACAS will end up in a forced sale, ACAS' share price and its NAV will likely be quite a bit closer. ACAS should then have the ability to raise capital to enter distress situations and to handle the business that first made me interested in it. Once the creditor crunch is over, ACAS' need to be coughing up penalty payments and other nasty earnings-impacting surprises will be replaced with the ordinary market risks we accept when we consider doing business.
Why hold ECAS to get a double-discount if ACAS hopes to get rational pricing? ACAS clearly expects someone to show up in the eventual future with an appetite for a mature portfolio of international investments. To the extent ACAS has already bundled them, ACAS can offer an interest in ECAS and the deal would be quick. Otherwise, the parties would dicker over which stocks would be in the basket, etc. This way, ACAS can say: "Here are the investments we put together while assembling a diverse portfolio in Europe, do you want a third?" and there's no need to quibble over which stocks are at issue. The deal will be faster when it happens. Since speed is an asset at ACAS, management is sensible to maintain preparedness even though the short-term result is NAV lunacy. So long as management doesn't sell ECAS at this crazy price, nobody is hurt except shareholders who bail from impatience.
With ACAS' NAV on the rise and the credit situation seemingly on the right track, investors who accepted stock-only dividends last year at $3.2199/sh are looking to be in good shape compared to those who were willing to take cash instead of discounted shares. Between my $1.80 purchase and the share dividend, my own basis has declined considerably. From my current position, I expect that as ACAS' NAV improves I'll see black ink again.
Slide 33 gives some color on ACAS' capacity to keep doing business. ACAS' closure of 7 offices and its slashing of headcount doesn't leave ACAS an empty shell waiting for the roof to collapse when creditors knock. ACAS retains 8 offices, 32 investment teams comprising 95 investment professionals, a 20-person operations team (to provide expertise and support to portfolio companies), and an audit and valuation team that reviews investments to do due diligence and portfolio monitoring on an ongoing basis. ACAS has folks whose jobs are to syndicate debt to third-party buyers, folks who perform various legal and human resources functions ... ACAS is a going concern, not an empty box of stock certificates.
ACAS appears entirely prepared for an active future.