ACAS Buys ... ACAS!

American Capital Ltd. announced this week that in August it began buying back shares of its own stock on the open market. August purchases totaled 4.9m shares at an average price of $8.12, and September purchases through the 15th of the month had reached 4.23m shares at an average price of $8.31. In all, ACAS has spent $75m on share buybacks, and is still buying. Share retirement at the time of the announcement reached 9.13m shares.

The headline of the press release delivers the punch line: ACAS, which at the moment isn't subject to BDC dividend-paying requirements because of its failed RIC test, has a policy governing share repurchase that's based on factors like operational issues and debt servicing. In the past, ACAS could not spend a material portion of profits on share buybacks because it was obliged to make dividend distributions based on its corporate taxable income (not its per-share taxable income). Now that ACAS is free from BDC-related dividend-paying obligations, it's freer to do things like share repurchases.

In the past, the Jaded Consumer's take on ACAS share repurchases was: don't hold your breath. The recent announcement suggests that the "really slick" idea for cash I'd hoped for is actually pretty simple. Based on the $13+ NAV ACAS announced having at the end of last quarter, ACAS' share repurchases were made at nearly $5 below the value behind each share purchased. (Realize that although the theoretical value of ACAS' holdings logically vacillates with the global and local economic and competitive environments that also impact all the comparable investments trading in liquid markets, ACAS only calculates fair-value estimates for public consumption on a quarterly basis; the recent economic turmoil naturally creates increased uncertainty regarding the value of ACAS' portfolio components, and likely impact on the value of target comparables. Thus, the average of $8.21 spent per share doesn't result in $4.95 per share in recaptured NAV to distribute across the remaining shares, because the NAV was moving independently of the share purchases.) But think about ACAS' management: it's been showing consistent NAV improvement for a nice string of about 8 quarters, and it doesn't want to lose its streak. What does the buyback do for it?

First, $4.95 per share on 9.13m shares is not the same as $4.95 per share on all ACAS' remaining shares; it's like getting $45m to allocate across the shares ACAS has remaining. At the close of 2Q2011, ACAS had an outstanding share count of 345.1m. Now, let's revisit what I wrote the last time I opined on share buybacks:

Buying shares doesn't lead to realized gains (imagine if it could treat issuance as a short, and close the positions it opened north of $40!), and offers no benefit to the bottom line.

This means that the "profit" of 18.36¢ per share (that is, remaining outstanding share) has just been made, tax-free. Yes, I realize that ACAS has loss carryforwards and wouldn't pay tax this year, but this is a "profit" that has several attractive features:

• Doesn't lead to reduction or loss of ACAS' valuable loss carryforward (in other words, the lack of a tax payment isn't just temporary; it's real)
  
• Doesn't push ACAS closer to being required to pay a dividend
• Doesn't cause confusing one-time impacts likely to be misread or dismissed by those reading the next quarterly report, but instead has a long-term impact on the per-share NOI, NAV, and other interesting metrics because it reduces the denominator by which the company's metrics are divided into per-share metrics.
• Did I mention that since the effect isn't taxable, neither ACAS nor shareholders bear a tax burden for the transaction even though it raises NAV 18¢? Which at a 35% tax rate, means it's identical to having earned and paid tax on 28.25¢?
  

Now, offsetting this 18¢ gain is whatever happened in the market to ACAS' portfolio companies' comparables. Yes, the comparables by which ACAS' portfolio is valued have surely been impacted by the recent market hit, and with them also ACAS' fair-value numbers for its holdings. This will work against the 18¢. But since ACAS is ahead on its debt repayment, and is generating cash it can use for things like share repurchases without putting itself behind the 8-ball on dividend obligations, it can afford to spend even more money: at the close of 2Q2011, ACAS held cash and cash equivalents of $186m. With neither a dividend obligation (the current repurchase policy places dividends and share buybacks within management's discretion based on share price relative to NAV) nor a debt repayment obligation (it pays interest, but hasn't got a principal obligation due for the near future), ACAS is free to game this for the benefit of shareholder value. As shareholders, management has a certain incentive to build share value.

The fact that ACAS can do this same trick again before the close of the quarter (it's got another $75m, after all) is interesting. The fact that ACAS could turn unproductive assets into share-buyback fodder is also interesting. Since ACAS hasn't been exactly setting acquisition records, the lost opportunities in not buying new portfolio companies while on sale may not be a big deal. And this makes sense: many people who'd be trying to sell their company under these conditions would be doing so out of conviction that the company won't last until conditions are better. Why would ACAS take a chance like that when there's a sure thing in-hand?

Mind you, I feel strongly that ACAS should be doing great things with its distressed-situations analysts – and strongly want to see outstanding purchases that will pay off in spades as the market normalizes – but perhaps the biggest contribution they've added is to keep ACAS out of deals on the basis that they're just not worth the risk.