Monday, August 9, 2010

On ACAS following 2Q2010

Thanks for the Anonymous post trying to point out the weak parts of the ACAS story – the more people have to think about, the better. ACAS' 2Q2010 presentation is worth looking at – the slides, at least, if you don't think you have time for the whole presentation.

I do not suggest ACAS should refinance immediately – refinancing was, after all, an expensive undertaking and I expect ACAS to enjoy being out of the refinancing market for some time. However, over the long run, it's an issue that will recur due to the restriction in the new debt limiting the use of funds raised by subsequent debt. I don't see this being an issue before the 2012 time frame. I see this being an issue when ACAS is wanting to be more levered than it is. At present, achieving ACAS' maximum allowable leverage doesn't involve de-levering.

ACAS won't worry about that soon. Looking at 2Q2010 presentation slide 15, ACAS also plans achieving leverage in the future using on-balance-sheet securitizations, a strategy with which ACAS' management has apparently had both experience and success at its publicly-traded controlled fund AGNC. Thus, ACAS may seek future leverage with investment partners on terms that are more attractive than generally available from banks.

Cash flow isn't operating income. ACAS' realized losses washed out its NOI while providing positive cash, preventing a dividend-related liquidity crisis in the near term, but the accounting profits (taxable income) at portfolio companies that lay behind the NOI figure should not be mistaken for positive cash into ACAS. ACAS is paying lots of interest on the debt whose nonpayment is still mounting. To combat this, ACAS plans improving its margins by dropping its interest rate another percentage point by the end of the year through repayment of secured debt. (see 2Q2010 presentation slide #15) (Note that Anonymous seems to overstate the restriction on repayment; the make-whole payments protect only a small subset of the new debt, most of which is subject to repayment at will without penalty, and some of which has a mandatory repayment timetable within the time frame described by Anonymous. If ACAS makes its planned early repayment, it will do so without penalty.) NOI is just coming off cyclical lows, and should improve – and with it, the internal metrics of the companies providing the NOI.

On the other hand, although nonpayment is worse sequentially – nonpaying loans have grown from $671m cost at the end of 1Q2010 to $686m cost at the end of 2Q2010 – non-accrual has improved y/y from $996m cost on non-accrual in 2Q2009. "Past due" loans stand at $57m (cost), down from a peak of $209m at 3Q2010. The benefit to ACAS of having a non-accruing loan that isn't past due seems somewhat mysterious to me just now, though. The fact that ACAS makes a deal for forebearance to allow a portfolio company to reinvest instead of pay interest doesn't mean ACAS ends up with either operating income or interest payments; it means ACAS is helping portfolio companies to avoid the vortex they're circling. It might promise some better odds of future recovery, but from where we stand out here it's hard to measure that benefit. Still, ACAS' focus on organic growth within portfolio companies and in supporting add-on acquisitions suggests that ACAS' efforts to support portfolio companies in their time of need has a strategy beyond improvement in the prayer life of executives. (See 2Q2010 presentation slides 20 & 23).

I note that although 2Q2010 has significantly more NOI than 2Q2009, its NOI was sequentially down from the 1Q2010 quarter. The NOI decrease could be partially explained by the increase in non-accruing loans over the quarter, but this isn't all of it.

The upside is in two hard-to-predict parts: recovering investment values and evaporating NAV discount. This is necessarily a lumpy ride. Depending on the economy (operating results) and the markets (multiples), we could have some significant backward movement while we're underway. Comparing the realized earnings to the FAS-157-compliant SEC-reported "earnings" shows ACAS negative except in improvement in unrealized gains.

The BLTs don't seem to be performing as planned at all. Repayment of debt associated with the superior debt classes issued by the BLTs is something I haven't measured, but the "half ACAS' cash" conclusion may indeed be the number. The opacity of ACAS' CDO investments prevents me from making any intelligent statements about them, but I notice that management has long since stopped using the CDOs as an example of how FAS 157 misprices ACAS' assets. Conclusion: management agrees that the CDOs (like the commercial mortgage-backed security investment once touted as expected to perform through maturity, despite being valued poorly as residential CDOs were collapsing) are essentially worthless.

To the extent ACAS needs cash, ACAS will be depending on exits. Fortunately, ACAS has been strong on making exits. Moreover, ACAS' focus on debt and securitizeable mezzanine business going forward would, if successful, result in quicker exits and less equity exposure. (see 2Q2010 presentation slide 18) With respect to "earnings" though, ACAS' reversal of unrealized losses and its increases in unrealized gains will likely keep it (and its NAV) looking good in its quarterly reports. However, as pointed out by Anonymous, most of ACAS' writedowns have been in equity. Most of the exits, however, have been in debt: of $351M of 2Q2010 cash realizations, only $45M came from equity. The rest has been debt. Retaining equity that stands a fair prospect of turning around with the economic recovery is attractive.

As depicted on 2Q2010 presentation slide #9, the sale of assets has been near recently-reported fair values. 2Q2010's exits at 7.7% above NAV are better than the within-2%-of-fair-value amounts that have characterized exits since 3Q2008, and it'll take some time to ascertain whether this represents a fluke or a trend. In the immediately prior quarter, exits were 3.7% below last-reported fair values. Both numbers are likely pulled off parity by a small number of outlier exits, and may be useless to shareholders in estimating the value of likely future exits, other than to reassure them that exits are plausible near reported fair values. Since management wants more than reported fair values from some of its investments, management will likely hold on to some well-performing investments for some time.

On the other hand, some of that equity isn't coming back: it died. ACAS borrowed money and lost it in deals that went south, and will have to repay it with the profit from its surviving deals. We won't be seeing $40 shares of ACAS any time soon.

But, as suggested by Anonymous, seeing $15-$20 in a handful of years is plausible. In my view, it will turn largely on macro-economic conditions that impact the entire market's profits and multiples. Considering that ACAS' 22% growth in NAV came after the effect of dilutive issuance, and that ACAS continues to hold a significant fraction of equity (including well-below-NAV-valued ECAS), the prospect for significant equity-driven return seems good – provided ACAS manages its liquidity concerns.

Reducing average leverage to 0.6 to 1, dropping interest rates to their lowest tier available under the newly-refinanced agreements, and lowering the principal on which debt will be paid will all reduce forward risk and improve forward margins. Raising new managed funds will enable ACAS to realize fee income without holding risk, allow ACAS to leverage due diligence overhead and internal resources to develop income beyond that achievable with ACAS' own funds, and enable ACAS to contract to enjoy potential upside like upside participation when return goals are met. Securitizeable mezzanine finance will both shorten the investment cycle and de-risk the portfolio. Focus on growing existing investments organically will allow ACAS to invest in what it knows, picking well-understood known winners for add-on investment in anticipation of preparing them for resale as they come off cyclical lows both in internal metrics and in terms of external multiples. Although ACAS is currently free under its debt agreements and the BDC Act to declare and pay dividends, the lack of an apparent need to declare a dividend this year or next will allow ACAS to maintain and recycle capital on hand for the near-term future.

In the more distant future, ACAS may market itself as an income stock, but in the meantime it's a holding company with no tax expense and I look forward to observing its performance improving book value. I'm optimistic that NAV improvement will continue as the economy avoids further collapse, and as ACAS proves its capacity to do profitable business over time its NAV discount may dissipate. Even if it doesn't, recycling funds into high-value new opportunities created by the economic collapse will offer returns by which ACAS will reward shareholdes with (ultimately) statutorily-mandated ordinary income distributions in the form of annual dividends.

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