Description

Buy American Capital Ltd. - The Street is Blinded by ACAS’s History

American Capital’s recent history is not pretty: it’s a busted Business Development Company (BDC) which last restructured in Q2’10. The company has stopped paying dividends, and is trading at a 30% discount to its USD20.54 NAV.

The Street has been burnt by management’s slow progress; however, ACAS turned the corner, when the board approved management’s plan to spin out two new BDC’s. I use a sum of the parts valuation to show that the restructure and spin will unlock value and create 40% upside in 9 months. The Street is blind to the fact that the tide has turned for American Capital.

                ACAS is Unloved by Dividend and Special Situation Funds

Dividend investors, the natural buyers of BDC’s, have no interest in ACAS which last paid a dividend in Q4’08. Instead of paying dividends, management has returned significant amounts of cash to shareholders through share buy backs.

In April 2014 the company announced that it was planning to restructure and the stock traded up 11% on the day to USD15.80. Special situation and event-driven investors, who would ordinarily jump into a stock like ACAS, have become wary of the company because it took management a further 8 months to release details of the spin and it took a total of 9 months for the plan to receive board approval.

ACAS is out of favor with all of the natural buyers which creates a great opportunity to buy at a significant discount. Shares will trade up towards their USD20 value when management announces a definitive date for the spin. I expect the spin to take place in 3Q’15 and for further details to be publicly available this summer.

                ACAS’s Portfolio Transformation is Misunderstood

The restructure is messy and revolves around a number of tax and regulatory requirements. The Regulated Investment Company (RIC) regulations set strict limits on the assets which can be held by a BDC. In order to obtain tax-advantaged RIC status, management has transformed ACAS from a highly leveraged book of CLO equity, middle market private equity buyouts and subordinated securities into a book where almost 55% of fair value is tied up in RIC friendly senior floating rate debt. The market has not recognized this change or given management credit for the increased quality of the firm’s assets.

                ACAS’s Spin-Off is Partially Taxable

Management expects that the spin-off of one BDC will be tax-free, and that one spin-off will be taxable. This is an added cost and complexity which may put off some investors. While I believe that the tax cost to most investors will be zero, the tax on this transaction could be as much as USD0.75 per share.

The Spin-off

The board has approved plans to transform American Capital Ltd (ACAS) into a standalone investment manager and to spin the assets currently held at American Capital Ltd. into two new BDC’s. Post-spin, the shareholders will hold shares in three listed entities which should be valued at USD20. The current share price is USD14.20 and the additional value is driven by:

                American Capital Ltd (ACAS)                                                                  +USD1.21 per share

ACAS will cease to invest on its own balance sheet (with a couple of temporary exceptions) and become a pure play investment manager. Post-spin ACAS will replace American Capital Asset Management LLC as asset manager for the American Capital private equity funds, listed REITS and CLO’s.

ACAS will be valued at 13x EV/EBIT post-spin (see page 10 for details on the expected multiple). In addition, management will achieve the targeted cost reductions of USD25MM p.a. and receive the expected reimbursements of USD46MM p.a. from the new Spin Co’s ACI and ACG&I. ACAS will retain its USD434MM tax asset.

                European Capital                                                                                     +USD0.65 per share

The proposed restructuring will not affect the European Capital fund. American Capital Ltd. is currently the investment manager and only investor in the European Capital fund and this will remain the case post-spin.

In Dec. 2014 European Capital sold its largest portfolio company Farrow & Ball which accounted for around 25% of fair value. This transaction substantially reduced the risk in the European Capital book and demonstrated management’s ability to realize significant profits. Farrow & Ball was sold for around USD430MM which was more than 20% above marked fair value. This transaction and other sales at European Capital lead me to expect that the fund will be valued at NAV by the market post-spin. Ultimately, management is likely to spin-out European Capital or open it to outside investors.

                Spin Co 1 - American Capital Growth & Income (ACG&I)                    +USD2.56 per share

ACG&I will be managed by ACAS and will focus on American Capital led buyouts, senior floating rate loans and hold the portfolio of CLO equity. The company will be taxed as a RIC and will pay an 8-10% dividend

ACG&I will hold around USD1.6bn in senior bank loans and USD1.4bn in buy-out investments previously made by American Capital. The BDC will continue to invest in new private equity deals sponsored by American Capital. While the valuation, transparency and liquidity of the bank loan book will be good under all reasonable scenarios, it is very difficult for outside investors to value the fund’s private equity investments.

I expect that the bank loan book will be valued at NAV by the market and that the private equity portfolio will be valued at a 20-30% discount to NAV. This discount is in line with the discounts I see on other similar assets, including the private equity investments at European Capital and Prospect Capital Corporation. ACG&I will trade at a 10% discount to NAV post-spin.

                Spin Co 2 - American Capital Income (ACI)                                            +USD1.54 per share

ACI will be managed by ACAS and will focus on lending to third-party buyouts. The company will be taxed as a RIC and will pay an 8-10% dividend. This spin-off is expected to be taxable. Given the wide range of possible tax rates, I do not attempt to estimate tax payable; however, I estimate the taxable income to be USD1.81 per share based on a USD14.20 purchase price.

The ACI portfolio will be a typical book of middle market loans and will have a diversified mix of non-control/non-affiliate debt and equity investments. The fund’s portfolio will be very similar to the one held by Golub Capital and as a result, I expect ACI to trade at NAV like Golub Capital.

Risks

The key risks are:

-ACG&I and ACI fail to earn tax-advantaged Regulated Investment Company status

-ACI and ACG&I fail to obtain sufficient leverage (I expect 0.6:1 Debt-to-Equity) or the covenants on the debt are overly restrictive 

-with the exception of the energy industry (ACAS has relatively low exposure to energy), defaults are expected to remain low in 2015. An increase in defaults could result in pre-spin losses at ACAS or write downs at ACI and ACG&I post-spin

-ACAS’s mortgage funds (NASDAQ: AGNC and NASDAQ: MTGE) account for the bulk of the pre-spin fees. Any disruption to the REIT or mortgage market would have a negative impact on ACAS’s valuation. 

-a general sell off of BDC’s and asset managers may increase the NAV discount and decrease the EV/EBIT multiple applied to the asset manager

Current Business

ACAS originates, underwrites and manages middle-market private equity buy-outs, buys structured products and makes loans to a range of businesses. ACAS has USD21bn in assets under management including USD7bn at ACAS and USD14bn of externally managed capital in 9 private and 3 listed funds. In addition to being a BDC, ACAS was a RIC when it IPO’ed in 1997 and was one of the biggest and most active, publicly traded, buyout and mezzanine lending firms prior to 2008.

     Discount to NAV

ACAS currently trades at a 30% discount to its USD20.54 NAV which is a large discount compared to the firm’s peers. American Capital trades at a large discount because the firm:

     1-has relatively poor asset quality and had large write downs (more than USD1bn) in 2009/10

     2-pays no dividend

     3-has lost its RIC status and is subject to federal taxation

Fig 1: NAV Discount of BDC Company Peers

     Asset Quality

In 2008 ACAS reported USD3.4bn in unrealized losses. The company went on to realize USD1.4bn of losses in 2009 and 2010. ACAS currently has the poorest asset quality (as measured by non-accrual loans as a percentage of fair value) of the major BDC’s. While Fifth Street Finance Corp. had a similar level of troubled loans in 2009, Fifth Street management has substantially reduced their exposure to non-accrual loans.

Fig 2: Non-Accrual Loans as a % of Fair Value

      Loss of RIC Status and Current Taxation

From 1997 to 30-Sep-2010, ACAS was taxed as a RIC under Subchapter M of the Internal Revenue Code. RIC’s, like REITS, are not subject to federal income tax on income and capital gains which are distributed to shareholders; however, RIC’s are subject to a number of restrictions and are not permitted to carry forward NOL’s.

ACAS dropped its RIC designation in September 2010 and is currently taxed as a C corporation. This change allowed the firm to preserve USD786MM in net loss carry-forwards (USD434MM in deferred tax assets) which were accumulated during 2008/09. ACAS’s tax status does not affect its status as a BDC.

     Dividend Payments

With the exception of ACAS, the BDC’s listed below are all RIC’s and, as a result, are required to pay out 90% of their income to shareholders in order to retain their tax advantaged status. 

Fig 3: Dividend Yields of Selected BDC Peers

     Third Party Funds Managed by American Capital Asset Management

 American Capital Asset Management (ACAM) currently manages 12 funds and CLO’s which will be managed by ACAS post-spin.

Fig 4: Funds Managed by ACAM

 European Capital makes equity, mezzanine and senior debt investments in Europe. European Capital and its manager European Capital Asset Management Limited are both wholly-owned affiliates of American Capital, Ltd. European Capital follows a similar strategy to ACAS (invests in private and public companies and private equity buyouts); however, European Capital is not eligible for tax preferred RIC status.

Post-Spin Valuation

In order to value ACAS post-spin we must: a) determine the fair value of the BDC’s and their likely premium or discount to NAV and b) value the new management company.

     Reasonableness of Current NAV and Asset Fair Value

BDC’s such as ACAS are required to ensure that at least 70% of their assets are ‘qualified’. Qualified assets are illiquid securities of small and medium-sized companies. This asset mix makes it difficult for outsiders to determine true fair value. American Capital is doubly difficult because it also acts as a financial sponsor and uses its BDC as a private equity buyout fund. I will attempt to form a view on fair value by assessing the reasonableness of management’s valuation inputs.

BDC’s are regulated under the ’40 Act and are not required to create a general loss reserve like a bank. ACAS is required to mark its investments at fair value. Accounting Series Release 118 recommends determining fair value by using:

     -an earnings multiple

     -a discount to the market price of a similar liquid security

     -yield-to-maturity

     -or, helpfully, another method

          First Lien Loans and Senior Debt

If we use yield as a proxy for risk ACAS’s first lien book has a similar risk to the leveraged loan market as a whole. ACAS’s first lien loans yielded 4.7% at 3Q’14 which is close to the 2 year average yield of the LevLoan 100 index. The yield on the LevLoan index rose at year end 2014 which would imply a decline in the value of ACAS’s loan book during Q4’14. Based on yield, the risk of ACAS’s senior loan book is in line with its peers

Fig 5: ACAS Senior Debt Yield Compared to Peers

At 3Q’14 the total senior/first lien book had a fair value of USD2.3bn. ACAS generated around USD2bn in cash in the first 3 quarters of 2014 and bought USD1.6bn of senior floating rate loans. These new loans, which account for almost 70% of the current loan book, are representative of market pricing and terms at the time they were written. As a result, I expect that the market will value the loan book at NAV post-spin.

          Mezzanine Debt

If yield is a proxy for risk, ACAS’s mezz book (USD548MM at cost and USD392MM at fair value) is materially more risky than its peers. Around 45% of mezz loans are classified as non-accrual and PIK principal appears to be USD115MM. Reasonable investors would apply a large NAV discount to the PIKing and non-accrual loans in the mezz book.

Fig 6: ACAS Yield on Mezz Debt Compared to Peers

The vast majority of ACAS’s mezz investments are related to ACAS’s buy-out investments. In the run up to the spin, ACAS’s management are likely to reduce their exposure to sponsored private equity investments and mezz debt. I expect that the market will value the mezz book at a 20% discount to NAV in line with its valuation of ACAS’s other control investments.

          Preference Shares

The preferred book relates primarily to control investments made by ACAS’s buy-out team. While there is limited information available on valuation metrics used by ACAS’s peers to value preference shares, we can infer that ACAS’s books is significantly more risky than Apollo’s.

Fig 7: ACAS Yield on Preferred Shares Compared to Peers

ACAS’s management mark the preference share book at USD150MM (cost USD153MM). The fair value of the largest preference share position is USD90MM; however, the median position size is USD3.5MM. As a result of its size, I expect that the preferred book will be largely ignored by the market; however, I value it at a 20% discount to NAV.

          Equity

ACAS does not provide sufficient information to determine the reasonableness of the valuations in its equity book. While the average discount rate of 15% (see Fig. 9) may be reasonable, the minimum discount rate of 4% is inappropriate for any equity other than a cash box with a finite life. The average terminal growth rate of 3% is probably ACAS’s estimate of long term US GDP growth and seems reasonable. While I would love to invest in a business which can grow at grow at 7% in perpetuity, I think that the maximum terminal value is absurd.

The 20% discount to traded companies seems reasonable, while the 30% premium may be the result of a small sample size or differing growth rates. The average control premium of 8% seems low, I would have expected the average premium to be in the region of 15%. The use of a sales multiple is interesting and is typically used for to value unprofitable businesses. Broadly speaking, the average metrics appear reasonable; however, a reasonable investor would value the equity book at a 20-30% discount to NAV to reflect the risk and illiquidity associated with the equity of private middle market companies. 

Fig 9:8ACAS Equity Valuation Methods and Metrics

          Structured Products (CLO’s and CMBS)

ACAS’s CLO book is broadly priced in line with its peers.

Fig 9: ACAS Yield on CLO’s and CMBS Compared to Peers

Fig 10: CDR and CPR Estimates

ACAS’s management provide some additional color on their CLO book including the Constant Prepayment Rate (CPR) and Constant Default Rate (CDR). The average CDR of 1% is low; however, this figure is in line with current default levels (the long term average CDR should be at least 3-4%). The average CPR is very high and implies that large amounts of cash are being spun off by the CLO book.

An inflated CPR will increase the value of both the senior and equity tranches (cash will be returned sooner than anticipated). An artificially low CDR will also increase the value of the senior tranches by a little and equity tranches by a lot. Without the servicer certificates or Bloomberg or Intex, it’s impossible to determine whether ACAS’s valuations are reasonable; however, I believe that the average CDR is too low. Many of ACAS’s CLO investments are 2006, 2007 and 2008 vintage and many older loans were refinanced during 2014. While refinancing activity was high in 2014, it is unreasonable to assume that refinancing will continue at the same rate.

The current fair value of ACG&I’s CLO equity book (subordinate notes) is USD221MM and the fair value of ACI’s CLO book is USD146MM. I think that management is overstating the fair value of its CLO investments especially the CLO equity held by ACG&I. I value the CLO equity book at a 20% discount to NAV and ACI’s CLO book at a 5% discount to NAV.

          Loan Defaults and Non-Accruals: Leveraged Loan Defaults

According to S&P/LCD’s latest quarterly buy-side survey (Dec. 2014) the average buy side manager expects that the default rate will be 1.64% in 2015 and 2.52% in 2016. This compares favorably with a 2014 default rate of 3.25%. When considering the 3.25% default rate it is important to note that the Energy Future Holdings (EFH) default increased the default rate by 3.5% when it filed for bankruptcy in April. Excluding EFH the default rate for 2014 was around 1%.

          Loan Defaults and Non-Accruals: HY Bond Defaults

The junk bond default rate for 2014 is around 2% according to Moody's who expect the default rate to remain around 2% in 1H’15. However, Energy companies constitute around 17% of the high-yield bond market and a sustained decline in the price of oil may lead to a sharp increase in default rates.

          Current Industry Exposure

ACAS’s portfolio is largely diversified and investors have limited exposure to oil prices.

Fig 11: ACAS Portfolio Exposures by Industry

          CLO Tranches and Energy Industry Risk

S&P surveyed 700 CLO’s and found that the average CLO had 3.3% exposure to energy which is much lower than energy exposure in the junk bond market as a whole. The tranched nature of a CLO means that any losses will hit the lower tranches first. Without access to Bloomberg or Intex it is not possible to assess the impact of the energy related losses on the tranches held by ACAS; however, 2013/14 vintage CLO’s are likely to have high (~20%) exposure to energy.

         Expected Dividend Payments

Prior to 2008, ACAS was simply one of many listed BDC’s. The company traded at around 1.3x NAV as investors bought the dividend without regard to the underlying value. In 2009/10 ACAS was forced to make more than USD1bn in write downs, cut its dividend to zero and restructure its debt obligations. As a result of the dividend cut ACAS lost its tax advantaged RIC status and convert to a C Corp. for tax purposes.

As a C Corp., management began using cash flow to buy back 1/3 of outstanding shares and pay down debt rather than pay dividends. Management expect that both ACGI and ACI will pay a ‘market rate’ dividend; however, this assumes that ACGI and ACI will have access to debt financing. BDC’s are limited by statute to 1x debt-to-equity and ACAS’s current covenants limit the debt to equity ratio to 0.75:1. I expect that ACG&I and ACI will be managed with a debt-to-equity ratio of between 0.5:1 and 0.75:1. Both ACG&I and ACI should be able to pay out a dividend in the region of 8-10% which is in line with the dividends paid by the other major BDC’s and management guidance. I do not expect ACAS to pay a dividend. 

Fig 12: Return Earned at Various Levels of Leverage Given the Current Asset Mix

     Management Company (ACAS) Valuation

The restructuring means that, post-spin, fee income will replace interest and dividends as the primary sources of income. In line with management’s assertion that both ACG&I and ACI will pay market standard fees I assume:

                ACG&I                  -2% management fee and a 20% performance fee subject to a 8% hurdle rate

                                            -60% Debt to Equity

                                            -returns based on current asset mix (5.2%) and adjusted for leverage

                ACI                        -1% management fee and a 20% performance fee subject to a 8% hurdle rate

                                             -60% Debt to Equity

                                             -returns based on current assets (6.8%) and adjusted for leverage

Of the USD14bn in third party fee earning funds under management USD3.5bn (25%) are funds with finite lives (CLO’s and private equity funds). Three of the funds with USD1.1bn of fee paying capital have finite lives and were launched during or before 2007 which means that the vast bulk of ACAS’s fee earning assets are either long term, or permanent. Post-spin, almost 80% of fee earning assets will be permanent which gives investors a great deal of security around fee revenue.

USD25MM of current SG&A is for the benefit of assets which will be held by ACI and ACG&I. ACAS will continue to incur these costs and will be reimbursed by ACI and ACG&I. In addition, USD21MM of costs incurred by ACAS are related to the provision of services and advice to portfolio companies which will be spun out into ACI and ACG&I. These costs will also be reimbursed. Management has also instituted a cost savings program and expect to achieve cost savings of around USD25MM p.a. by the end of 2015.

I expect debt to be reduced to around 500MM which will be used primarily to fund the purchase of loans for ACAS’s CLO program. I assume American Capital creates one new CLO per year.

Fig 13: ACAS Financials

          Recent Asset Manager Spin-Offs and IPO’s

While the proposed ACAS spin transaction is unique, there are a number of recent asset management company spin-offs which give investors a glimpse into how the management company may trade post-spin.

Fig 14: Recent Comparable Asset Management Transactions

          ACAS Multiple

While the three managers above trade between 6-184x EV/EBIT, the major asset managers trade with multiples between 7-15x EV/EBIT. I believe that post-spin ACAS should be valued with a 13x multiple which is reasonable given the valuations of NSAM, FSAM and MDLY.

Fig 15: ACAS Post-Spin Equity Value

The 13x multiple is justified by the diversified (mortgage REIT, BDC, CLO and private equity) and largely permanent (almost 80% of fee paying assets are in permanent capital vehicles) nature of the funds which will be managed by ACAS post-spin. ACAS typically renews the management contracts with its permanent capital funds annually. In the event that ACAS is replaced as manager, the fund will typically pay a termination fee equal to 3 years of management fees (3-6% of fee paying assets). This termination fee is a substantial penalty, and I do not expect ACAS to be replaced as manager of its funds.

The 13x multiple is significantly less than the 21x multiple applied to MDLY and the insane 184x multiple applied to NSAM. FSAM is so thinly traded that the valuation is meaningless.'

     European Capital Valuation

While ACAS’s non-accrual book remains large compared to ACAS’s peers, management is improving its credit exposure by buying first lien loans and reducing its equity risk. ACAS’s European Capital fund reduced its equity exposure by 59% in December 2014 when it sold the paint manufacture Farrow & Ball.

At 3Q’14 European Capital had a NAV of USD766MM and was carried on ACAS’s books at USD678MM an 11% discount. Farrow & Ball was valued at USD331MM and sold at USD433MM a +23% premium to NAV. The fact that management was able to realize more than NAV for a buy-out investment like Farrow & Ball gives me confidence around management’s ability to sell risky buy-out investments for at least NAV.

Management has made comments to the effect that European Capital may sell its remaining equity investments and transform its self into a European debt fund. Ultimately, ACAS is likely to spin out European Capital or open it to third party investors at NAV. This would be a positive development for ACAS shareholders as it would eliminate the NAV discount and generate fees in the region of 1.5/20%. The base case scenario is that European Capital will trade at NAV.

Fig 16: Estimated Value of European Capital

     American Capital Growth & Income (ACG&I)

ACG&I’s portfolio will hold the debt and equity related to American Capital’s buyouts and ACAS’s senior floating rate loan portfolio. While the senior loan book should be valued by the market at NAV, the market is likely to place a discount on the USD750MM in buyouts and higher risk investments. The base case scenario (in grey) is that ACG&I will trade at a 10% discount to NAV.

Fig 17: Estimated Value of ACG&I

     American Capital Income (ACI)

ACI’s portfolio is relatively transparent and should be more liquid than the buy-out assets held at ACG&I. For the reasons outlined above, the base case scenario (in grey) is that ACI will trade at NAV.

Fig 18: Estimated Value of ACI

          Tax Impact of ACI Spin

As per management’s comments, ACG&I will be a tax free spin (it owns operating businesses through ACAS’s buyout business); however, ACI is a pure investment company and will therefore be taxable. Under Section 355 of the Internal Revenue Code, spin-offs are considered tax-free if they meet a range of requirements including that the parent and spin-co are engaged in an "active trade or business". As per § 1.355-3 (iv) (A) the active conduct of a trade or business does not include "the holding for investment purposes of stock, securities, land, or other property".

               Cost Basis Calculation

If an investor buys one share of company ACAS at USD14.20 and receives one share of ACI and ACG&I they will have to pay tax on a portion of their investment in ACI. If we assume that all three entities trade as expected immediately after the spin, the worst case scenario is that taxable income is USD1.81 per share.

Fig 19: Estimated Taxable Income per Share (USD14.20 Purchase Price)

     Dilution

ACAS has issued options over 54MM shares to management with strike prices from USD0.94 to USD49.63. While the maximum dilution is 54MM shares, the wide range of strike prices mean that dilution is likely to be less than 53MM shares. The exercise of all options with a strike of less than USD20 (53MM shares) will raise USD431MM in cash or ACAS.

Under the ‘40 Act, the number of options that can be outstanding is limited to no more than 20% of the outstanding shares of the company. ACAS has issued options on shares equal to just less than 20% and is therefore unable to further dilute shareholders.

Sum of the Parts Valuation

The table below outlines the sum of the parts valuation of USD20.20 for ACAS, ACI and ACG&I post-spin.

Fig 20: Post-Spin Sum of the Parts Valuation

Catalyst

1-management set a date for the spin and release additional information
2-management continue to realize marked fair value on their asset sales and use the proceeds to buy senior debt