American Capital Strategies ACAS
August 29, 2000 - 12:37pm EST by
2000 2001
Price: 23.50 EPS 0
Shares Out. (in M): 0 P/E
Market Cap (in $M): 0 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Acas is a leveraged buyout/merchant banking firm that finances and advises middle market companies. They structure their deals to provide whatever financing is required and necessary: senior debt, subordinated debt with warrants, convertible preferred and equity. The overwhelming percentage of their transactions are sub debt/warrants deals with a 'minimum' hurdle rate of 18%. The RIC/BDC corporate structure allows ACAS to pass through ALL short-term capital gains, interest, and dividends to their shareholders. They pay no corporate tax if they pay out 98%. Long-term gains can also be passed through tax-free but may be retained and taxed, if the company deems that the better alternative. Acas is one of the few stocks that would currently appeal to growth, value and high yield investors.

I came to know this company threw the back door. I was a Lion Brewery shareholder that ACAS helped finance in a leveraged management buyout. I was struck by how profitable these transaction can be and after doing my due diligence on the company was convinced that it's one of the best investment opportunities I had ever seen. I have rarely seen an investment with all four of these characteristics.

(1) Great Management
(2) Great Business Model
(3) High Yield
(4) Low Stock Price

Great Management.
This is an allstar team. It's nice having Harvard and Yale graduates among management but more importantly is the experience they bring to the table. In this business you have to know what you're doing and also be very connected. Let's look at two of the key players and their credentials.

Vice-Chairman David Gladstones' record at Allied (ALLC) was incredible. When he started at Allied it only had $9M in assets and when he left it had $750M, producing compounded annual returns to shareholders of over 22% during his 15 years of heading the company.

Chairman Malon Wilkus ran private ACAS before it went public three years ago and it's instructional to see what he did with ACAS when it was a private company. Being a closely held ESOP, stated earnings were of course understated. (Nobody wants to pay a lot of taxes). There is no way of knowing exactly what his total rate of return was, (it was a private company), but in making an educated guess, it was nothing short of fantastic. A number we do know for certain is the equity performance of their portfolio companies at private ACAS. While the amount of capital employed was small, the annual percentage gains were not. From 1990 to 1997 the compounded annual returns were 47% for the equity portfolio. That bodes very well for public ACAS in the future.

My due diligence on ACAS is cursory in comparison to what ACAS puts their portfolio companies through. (A friend, who has been through it, likened it to a rectal exam!) While defaults are always possible, I think it more likely to stem from macro-economic events than a company-specific problem. Gladstones' books weren't fun reads but they were eye openers as to what is involved in lending to and investing in private businesses. Very few companies make the grade...less than 1 per 100.

HIGH YIELD---There are very few companies that pay a high ever-increasing dividend (currently 8.2%) in addition to potentially reaping very significant capital appreciation. ACAS is the perfect vehicle for self-directed IRA's. (Roth is to RIC as peanutbutter is to jelly). There are currently very few individual investors that make up the sharebase but it is growing. Institutions own most of ACAS with management owning about 18%. At some point investors will realize it's better paying 10 times earnings for a 20% long-term grower than buying the S&P at 30 times earnings for a 10% grower. (ACAS' 'real earnings' are overstated at all the financial websites because they include 'unrealized gains' from ACAS' stock and warrant portfolios).

GREAT BUSINESS MODEL---Very few companies offer the full finance package to middle market companies as ACAS does. When they act as principal in a deal it takes longer for the transaction to develop but it is far more lucrative. (More bang for the buck).

Acas specializes in ESOP's and with these transactions debt is paid off much faster than with non-ESOP's resulting in more rapid equity buildup. ACAS is ramping up deal production: their first year as a public company it was about 1 deal per principal and they are now nearing their stated goal of 3 deals per principal without compromising underwriting standards. (When money was too loose in the Summer of '98, ACAS preferred sitting on their hands and writing fewer deals than going below their 18% hurdle rate).

The one negative of the model is their dependence on the capital markets because of the RIC corporate structure. This reliance on the capital market is also a two-edged sword. In the Fall of '98 during the Asian and LTCM crisis, it was a terrible time to need capital and fortunately ACAS didn't have to do an equity offering at that time because the markets were effectively shut down and the price was too low. The flip side is they wrote some very nice deals because they had the capital and weren't afraid to lend it at the right price. Other financial institutions were pulling back but ACAS stepped up to the plate increasing the percentage of warrants received on the sub deals.

STOCK PRICE UNDERVALUED--Management is on record as saying they believe a 23% ROE is very achievable. Current advisory fees cover a large portion of overhead so everything else falls to the bottom line. They average 14% from the sub debt and another 6% from leverage. (They borrow at 8% lend at 14%.) As a Business Development Company (BDC), they are legally restricted to a 1 to 1 leverage ratio, one part debt to one part equity. I consider a future 23% ROE to be a very conservative estimate for several reasons.

(1) No value is given to the warrants at all. We are assuming any gains will be offset by losses in the portfolio. This is highly unlikely. (After 3 full years as a public company, Acas does not have even ONE non-performing loan!)
(2) The ESOP companies are objectively valued by third parties. In the past, strategic buyers have paid far more than fair value appraisals of ESOP's.
(3) IPO's as an exit strategy is not being considered. The portfolio companies are not high tech but there is a good chance in the future at least a few of the companies can be IPO'd at higher prices than other exit strategies. (OTWO, an ACAS portfolio company, just IPO'd a couple of weeks ago and produced far greater gains to ACAS than ACAS had conservatively estimated on their books).

I know some very conservative investors who won't buy ACAS because its too good to be true. Anything that has this kind of yield and future potential has to be very risky. That's the knee jerk reaction when you mention sub debt, warrants, and high yield. When you really analyze the company and strip it down to the basics, though, it's not difficult seeing how they get these outsized returns. A lot has to do with not paying Uncle Sam. On an operational basis the ESOP's greatly reduce or eliminate all taxes. On a corporate level, the RIC pays no taxes if the gains are all distributed. (When I receive them in my Roth these taxes will never be paid!) Most finance companies and banks pay a 35%-40% corporate tax and are forced to greatly leverage the balance sheet to make their numbers...ACAS does not.


(1)An ever-increasing yield is eventually going to appeal to a lot of investors when the 20% stock market returns are history.
(2) There has been a huge build-up of unrealized appreciation in ACAS' warrant and equity portfolios...and the market will take notice when ACAS earnestly starts harvesting this low hanging fruit.
(3) IPO's as an exit strategy will also start drawing attention to Acas' portfolio and investors will realize that these are not one-time events but will be taking place with regularity.
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