Deep Value in American Capital Strategies

American Capital Strategies (ACAS) was the only Business Development Company (BDC) listed in the S&P 500, until late last year. As a BDC, it holds loans and equity in small, unlisted companies (portfolio companies), providing funding and management expertise until the portfolio companies can be sold to other investors. It values ites portfolio at $8.5 billion. This was funded by a combination of equity capital and loans, of which $4.4 billion remain outstanding.

Naturally, last year it became more difficult to find other investors to sell their portfolio to. But that's not what really hurt. What hurt was the mark-to-market writedowns that reduced the nominal value of the portfolio by $1.2 billion. That, in turn, triggered violations of covenants on ACAS's debts. Its stock price went from $40 in 2007 to $20 last July, $10 in November, to a low of $0.58 on March 6, following the earnings report that revealed a loss of $8.13 per share.

But the loss was based on writedowns of portfolio assets, not operating income. And now we have an equally dramatic recovery in progress; the stock closed at $2.50 on April 9. Yet it is still trading at only 16% of the book value. As a BDC, it is required to distribute a high percentage of its net operating income (NOI) as dividends to investors; in 2008, stockholders earned $3.08 per share. For 2009, it has promised to pay $296 million in dividends, based on 2008 NOI. Given 205M shares currently outstanding, that would be $1.44 per share, for a 60% yield.

There is, however, a wrinkle or two.

The first one is that while IRS rules require BDCs to pay dividends, there's a temporary waiver in place (because so many BDCs and REITs have become too insolvent to pay cash dividends), which allows them to pay 90% of the dividend in stock. Newly-issued stock, that is. I cannot for the life of me figure out why anyone thinks that receiving a dividend in stock does them any good at all, since each shareholder still owns the same proportional value of the company's equity; other than some minor tax adjustments, it's a purely symbolic gesture. The company has made no commitment as to the use of stock vs. cash. An announcement is due June 15th.

The next wrinkle is potentially even more dilutive.

A BDC can only thrive if it can raise capital. ACAS cannot get new loans due to the covenant violations of previous loans. It could issue new equity, but its bylaws require new shares to be sold at no less than book value; not possible, with current shares trading so much lower.

The company has proposed a way out of this dilemma: a reverse stock split, to bring the share price back in line with the book value. Then, if the company needs capital, issuing new shares after a reverse split would help the balance sheet. Additional benefits, according to the proposal, would be to bring the stock price into a more respectable range (e.g., above $10), where it is once again acceptable to institutional investors. This would, the theory goes, provide additional liquidity, thus benefitting existing shareholders.

The worry, of course, is that the issuance of new shares would dilute existing shareholders. The question would be, how much? If done skillfully, attracting capital and making the stock more marketable would be a good counterbalance to the dilution. The ACAS management has a good track record, and it's good odds that they can again bring value to shareholders.

Other than the writedown of assets last year, the company continues to make money; only about 2% of their loans to portfolio companies are non-performing. So future earnings will generate additional dividends, probably before the end of 2009. But even without cash dividends, the stock is attractively valued. And if the markets continue to improve in general, they will be able to profitably exit more portfolio positions, thus raising capital for new investments.

If market forces continue to put pressure on the portfolio, however, I don't think it will make much difference whether the stock is reverse-split or not; having a respectable stock price doesn't make an attractive investment when your business sucks.

Disclosure: Long ACAS since 3/9/09

Comments

[andydee:]

"There is, however, a wrinkle or two.

"The first one is that while IRS rules require BDCs to pay dividends, there's a temporary waiver in place (because so many BDCs and REITs have become too insolvent to pay cash dividends), which allows them to pay 90% of the dividend in stock. Newly-issued stock, that is."

Actually, the waiver, I believe, permitted an additional 10% more than the existing maximum of 80% of the dividend in newly issued stock.

"I cannot for the life of me figure out why anyone thinks that receiving a dividend in stock does them any good at all, since each shareholder still owns the same proportional value of the company's equity; other than some minor tax adjustments, it's a purely symbolic gesture."

"Symbolism" AND "retention of liquidity". It is my opinion that, absent issues with liquidity and lenders reluctant to let even a bit of the "Current Assets" to go back to share owners, Malon and company would prefer to pay dividends in cash. If management had a choice, that's what they would do, imo. I don't think the holders of the unsecured debt will let them.

"The company has made no commitment as to the use of stock vs. cash. An announcement is due June 15th."

No later than June 15th. We could hear about it sooner than that, but, imo, after "favorable" Q1 results are announced - and after a favorable vote on the (now prel..) proxy, scheduled for June 11.

www.sec.gov/Archives/e...



"The next wrinkle is potentially even more dilutive.

"A BDC can only thrive if it can raise capital. ACAS cannot get new loans due to the covenant violations of previous loans. It could issue new equity, but its bylaws require new shares to be sold at no less than book value; not possible, with current shares trading so much lower."

I agree with your notion that capital will permit a BDC to "thrive". It can grow without new capital, in a welcoming environment - which we don't have now. BDCs can grow by using "realizations" - principal and interest payments by the existing portfolio companies as well as the occasional sale of a "mature investment", be that equity or debt.

However, I think you may have overlooked something important. Take a look at the last (successful) proxy. It gives ACAS an opportunity to sell 42 million shares below NAV. Those shares are not shrunk by the prel proxy being circulated now. Check out the current proxy and the one issued earlier this year. The 42 million shares mentioned in the Jan proxy was 20% of the outstanding shares as of Jan 6th, 2009, THE record date for that proxy.

"The company has proposed a way out of this dilemma: a reverse stock split, to bring the share price back in line with the book value."

No. A reverse split can only protect them from de-listing which may very well be a condition imposed by the lenders, or by NASDAQ.



"if the company needs capital, issuing new shares after a reverse split would help the balance sheet."

"Help" in the sense that it provides capital to take advantage of outstanding bargains in this environment.

"Other than the writedown of assets last year, the company continues to make money; only about 2% of their loans to portfolio companies are non-performing. "

As pointed out earlier, that's 2% at "Fair Value". Much higher if considered at cost...


"But even without cash dividends, the stock is attractively valued. And if the markets continue to improve in general, they will be able to profitably exit more portfolio positions, thus raising capital for new investments."

Agreed.

"If market forces continue to put pressure on the portfolio, however, I don't think it will make much difference whether the stock is reverse-split or not; having a respectable stock price doesn't make an attractive investment when your business sucks."

They are in a lot of different businesses, one of the many attractions BDCs have. But, certainly if the global economy does not get out of the "funk" it is in, and soon, by the end of 2010 for sure, things won't be very good for ACAS.

Are you an optimist? I think all "longs" must be.

Otherwise, play the other side.

Apr 12 03:18 PM

[toomuchgas:]

There is no guarantee that ACAS will want to remain a BDC. They can always convert to a regular "C" company and not have to issue dividends. Regardless, who knows what the "true" value of their investments are. Most are marginal companies that couldn't secure debt from any other source. Someday this co. may recover or it may go bankrupt.

Apr 12 04:06 PM

[Alan Young:]

I'm honored to have input from so many knowledgeable people. I see a very constructive discussion all around.

Tourguide: I agree that buying back debt would appear to be a good tactic.

Augustus, NMB, and User 105499 -- okay, I will admit to some confusion here-- I took the point (perhaps thoughtlessly) from the company's SEC filing, here:

phx.corporate-ir.net/p...

... but perhaps I misinterpreted their argument -- or was it bogus? I'd be happy to get more clarity about this.

Apr 12 04:15 PM

[zorro6204:]

I find it difficult to believe that a company in technical default on its bank loans could float an equity offering, much less attract institutional investment. Until they resolve their covenant problems, in a similar manner to MCGC, I don't see this going anywhere but marking time. ALD is in the same fix, with a similar set of problems.

Apr 12 05:25 PM

[BDCLover:]

Someone is buying millions of dollars of ACAS bonds on the open market for approx. 42% of par. There is a rumour out there that ACAS is the one buying the debt but there is no confirmation. ACAS is also paying down the CLO debt (not the wisest move in my mind but by the terms of the CLO, ACAS must pay down debt if the CLO contains any defaults).

Apr 12 10:26 PM

[Stockmajor:]

American Capital will survive and thrive. The return for the long term holder will be outrageous!

Apr 12 11:34 PM

[skucount:]

No matter how you look at it, ACAS's stock price is trading at a massive discount. It is a cash machine and the worst is behind them. MTM rule changes, purchase of ECAS, and increasing cash by suspending the dividend last fall have all worked in ACAS favor long term. My guess, in 2 years the stock will be above $17 (NAV) and have a 12% dividend at minimum. I've been buying, holding, and trading for a while. This one is a keeper for the long term if you can stomach the next 8 months as the economy levels off.

Apr 12 11:55 PM

[Leverage, A...:]

The bearish case misses the role of a return of confidence. I see a great quantify of cash that is parked in non risk assets that in fact is looking and waiting to take risk and to earn a substantial real return.

What kind of stimulus are we going to see when it dawns on fund managers who are underinvested in risk assets that they are on the wrong side of the market and will have to explain this to their bosses, clients and shareholders?

That said, I am not at all sure ACAS is only experiencing a 2% loss or non performing loan ratio. I am sure it is much higher currently.

Apr 13 08:33 AM

[not_my_busi...:]

Alan,

The arguement FOR the reverse split is to get the stock to a price that will remain listed (> $1) and will be OK for institutions to hold (> $5-$10). These accomplishment of these two items will indirectly facilitate more investment by stronger hands which indirectly can tend to push the $$/NAV closer to 1.

The only direct result of a RS is a higher NAV/share with usually a proportionate increase in the $$/share. The $$/NAV and the % ownership of existing shareholders remains unchanged directly.

Hope that help and congratulations on the courage of being able to say "oops".

NMB


On Apr 12 04:15 PM Alan Young wrote:

> I'm honored to have input from so many knowledgeable people. I see
> a very constructive discussion all around.
>
> Tourguide: I agree that buying back debt would appear to be a good
> tactic.
>
> Augustus, NMB, and User 105499 -- okay, I will admit to some confusion
> here-- I took the point (perhaps thoughtlessly) from the company's
> SEC filing, here:
>
> phx.corporate-ir.net/p...;p=irol-SECText&am...
>
>
> ... but perhaps I misinterpreted their argument -- or was it bogus?
> I'd be happy to get more clarity about this.
>
>
>

Apr 13 10:33 AM

[not_my_busi...:]

Andy,

Why do you insist on spreading false information when I already clearly corrected you on this on the Yahoo board?

You wrote:

"Take a look at the last (successful) proxy. It gives ACAS an opportunity to sell 42 million shares below NAV. Those shares are not shrunk by the prel proxy being circulated now. "

That statement is PATENTLY FALSE.

PLEASE just read this and stop spreading purposeful misinformation.

"If stockholders approve the Proposal, we may only sell ... up to an additional 42,812,640 shares of our common stock, which is 20% of the number of shares of common stock outstanding as of the record date, subject to adjustment for shares issued following the occurrence of events such as stock splits, stock dividends, distributions and recapitalizations ..."

NMB


On Apr 12 03:18 PM andydee wrote:

> "There is, however, a wrinkle or two.
>
> "The first one is that while IRS rules require BDCs to pay dividends,
> there's a temporary waiver in place (because so many BDCs and REITs
> have become too insolvent to pay cash dividends), which allows them
> to pay 90% of the dividend in stock. Newly-issued stock, that is."
>
>
> Actually, the waiver, I believe, permitted an additional 10% more
> than the existing maximum of 80% of the dividend in newly issued
> stock.
>
> "I cannot for the life of me figure out why anyone thinks that receiving
> a dividend in stock does them any good at all, since each shareholder
> still owns the same proportional value of the company's equity; other
> than some minor tax adjustments, it's a purely symbolic gesture."
>
>
> "Symbolism" AND "retention of liquidity". It is my opinion that,
> absent issues with liquidity and lenders reluctant to let even a
> bit of the "Current Assets" to go back to share owners, Malon and
> company would prefer to pay dividends in cash. If management had
> a choice, that's what they would do, imo. I don't think the holders
> of the unsecured debt will let them.
>
> "The company has made no commitment as to the use of stock vs. cash.
> An announcement is due June 15th."
>
> No later than June 15th. We could hear about it sooner than that,
> but, imo, after "favorable" Q1 results are announced - and after
> a favorable vote on the (now prel..) proxy, scheduled for June 11.
>
>
> www.sec.gov/Archives/e...
>
>
>
>
> "The next wrinkle is potentially even more dilutive.
>
> "A BDC can only thrive if it can raise capital. ACAS cannot get new
> loans due to the covenant violations of previous loans. It could
> issue new equity, but its bylaws require new shares to be sold at
> no less than book value; not possible, with current shares trading
> so much lower."
>
> I agree with your notion that capital will permit a BDC to "thrive".
> It can grow without new capital, in a welcoming environment - which
> we don't have now. BDCs can grow by using "realizations" - principal
> and interest payments by the existing portfolio companies as well
> as the occasional sale of a "mature investment", be that equity or
> debt.
>
> However, I think you may have overlooked something important. Take
> a look at the last (successful) proxy. It gives ACAS an opportunity
> to sell 42 million shares below NAV. Those shares are not shrunk
> by the prel proxy being circulated now. Check out the current proxy
> and the one issued earlier this year. The 42 million shares mentioned
> in the Jan proxy was 20% of the outstanding shares as of Jan 6th,
> 2009, THE record date for that proxy.
>
> "The company has proposed a way out of this dilemma: a reverse stock
> split, to bring the share price back in line with the book value."
>
>
> No. A reverse split can only protect them from de-listing which may
> very well be a condition imposed by the lenders, or by NASDAQ.<br/>
>
>
>
> "if the company needs capital, issuing new shares after a reverse
> split would help the balance sheet."
>
> "Help" in the sense that it provides capital to take advantage of
> outstanding bargains in this environment.
>
> "Other than the writedown of assets last year, the company continues
> to make money; only about 2% of their loans to portfolio companies
> are non-performing. "
>
> As pointed out earlier, that's 2% at "Fair Value". Much higher if
> considered at cost...
>
>
> "But even without cash dividends, the stock is attractively valued.
> And if the markets continue to improve in general, they will be able
> to profitably exit more portfolio positions, thus raising capital
> for new investments."
>
> Agreed.
>
> "If market forces continue to put pressure on the portfolio, however,
> I don't think it will make much difference whether the stock is reverse-split
> or not; having a respectable stock price doesn't make an attractive
> investment when your business sucks."
>
> They are in a lot of different businesses, one of the many attractions
> BDCs have. But, certainly if the global economy does not get out
> of the "funk" it is in, and soon, by the end of 2010 for sure, things
> won't be very good for ACAS.
>
> Are you an optimist? I think all "longs" must be.
>
> Otherwise, play the other side.

Apr 13 10:47 AM

[sticktoitiv...:]

"But the loss was based on writedowns of portfolio assets, not operating income."

Actually operating income declined last quarter from 284,000,000.to 67,000,000.

You should also be careful, acas isn't always straightforward with shareholders.

Apr 13 12:34 PM

[Phil10:]

Buying back debt is likely to furthr violate their bank covenants.

Apr 13 04:19 PM

[Jonathan Ch...:]

Some thoughts:
1. Buying debt at below face value will increase equity by the difference between face value of the debt and the amount paid. That is a good thing. However there are often strict limits on how much debt a company can buy back.
2. While a reverse stock split is only a paper exercise and does not change the equity situation, investment firms are often limited to buying stock with share prices above $5 or $10 dollars. the end result would be to increase the market available to buy the stock, which COULD result in increased interest, volume and a REAL increase in price.
3. The ACAS web site has not caught up with reality. An additional 10 to 15 million shares were issued as a result of the absorbtion of European Capital into ACAS. The 67.7% that ACAS had already owned was carried on the books as about $300 million, the market value of the European Capital shares. However since the total equity of the European operation can now be carried on the ACAS books, ACAS has picked up a net increase in equity of somewhere between $400 and $800 million shares. That will go a long way to cure the covenent violation.

I just purchased another 10,000 shares.

Apr 14 10:56 PM

[not_my_busi...:]

Jonathan,

To your point regarding limits on their ability to buy-back their public debt, there are no restrictions. This has been confirmed with mgmt.

NMB


On Apr 14 10:56 PM Jonathan Christopher wrote:

> Some thoughts:
> 1. Buying debt at below face value will increase equity by the difference
> between face value of the debt and the amount paid. That is a good
> thing. However there are often strict limits on how much debt a
> company can buy back.
> 2. While a reverse stock split is only a paper exercise and does
> not change the equity situation, investment firms are often limited
> to buying stock with share prices above $5 or $10 dollars. the end
> result would be to increase the market available to buy the stock,
> which COULD result in increased interest, volume and a REAL increase
> in price.
> 3. The ACAS web site has not caught up with reality. An additional
> 10 to 15 million shares were issued as a result of the absorbtion
> of European Capital into ACAS. The 67.7% that ACAS had already owned
> was carried on the books as about $300 million, the market value
> of the European Capital shares. However since the total equity
> of the European operation can now be carried on the ACAS books, ACAS
> has picked up a net increase in equity of somewhere between $400
> and $800 million shares. That will go a long way to cure the covenent
> violation.
>
> I just purchased another 10,000 shares.
>

Apr 15 06:42 AM

[not_my_busi...:]

Jonathan,

To your point regarding limits on their ability to buy-back their public debt, there are no restrictions. This has been confirmed with mgmt.

NMB


On Apr 14 10:56 PM Jonathan Christopher wrote:

> Some thoughts:
> 1. Buying debt at below face value will increase equity by the difference
> between face value of the debt and the amount paid. That is a good
> thing. However there are often strict limits on how much debt a
> company can buy back.
> 2. While a reverse stock split is only a paper exercise and does
> not change the equity situation, investment firms are often limited
> to buying stock with share prices above $5 or $10 dollars. the end
> result would be to increase the market available to buy the stock,
> which COULD result in increased interest, volume and a REAL increase
> in price.
> 3. The ACAS web site has not caught up with reality. An additional
> 10 to 15 million shares were issued as a result of the absorbtion
> of European Capital into ACAS. The 67.7% that ACAS had already owned
> was carried on the books as about $300 million, the market value
> of the European Capital shares. However since the total equity
> of the European operation can now be carried on the ACAS books, ACAS
> has picked up a net increase in equity of somewhere between $400
> and $800 million shares. That will go a long way to cure the covenent
> violation.
>
> I just purchased another 10,000 shares.
>

Apr 15 06:43 AM

[mikebrah:]

I just started investigating ACAS today after coming across it on an unrelated post. I just wanted to say thanks to the author and all the posters for an incredibly useful/helpful discussion flow.

Apr 16 01:05 PM

[Lilyput:]

A person shouldn't fall in love with a stock, but I fell in love with this one a long time ago. How can you not love a company that grows the middle market, is as diversified as any well managed mutual fund and has historically paid great returns to its shareholders? Malon is a 60's kind of guy and Ira is as ruthless as they come. It will be a great American tradjedy if they don't recover and prosper nicely. I have to believe they will solve their present problems and land on their feet. They are the GS of their market nitch.

Apr 22 10:38 PM

[Johnny Jones:]

As a loyal stock holder of ACAS, I feel that we are getting shafted by some items that I have heard about the news of the company. The thought of a reverse split when the shareholders stayed with you during the rough times, this will dilute the shareholders and I do not think that is taking care of your share holders. How can a company that states that only 2% of the companies are doing poorly and this means that 98% are doing well, not pay the actual dividends that were promised and then feel that they need to do a reverse split to gain more market value? I feel strongly that as the economy turns that the share prices will increase on their own, if the company is as great as you claim. How did it get to those great levels in the first place? By being a well diveersified company and handling businesses correctly to begin with. J. Jones, Sr.

Apr 26 11:13 AM

[BULLISH MR JIM:]

The purpose of the Treasury option to pay dividends in stock is to allow the BDC to avoid payment of federal income taxes (required if 90% of net income is NOT paid out as dividends). This temporary waiver allows the BDC to comply with the dividend requirement while retaining the cash and avoiding federal income taxes. BULLISH MR. JIM

May 01 06:27 PM

[notsosmart:]

by all the above everyone should realize its all ponzi & vegas.this game has so many ins & outs,rights & lefts,ups & downs etc. that confusion reigns supreme.advantage to the insiders who make legacy fortunes,by pay or manipulation, & then get out & park their swag in switzerland(glad to hide your tax free acct) or lichtenstein etc.ethics,honesty & trust are long gone never to return.it matters not what "ism" it is cause its the same.screw as many people out of as much as possible.the dumb-dumbs go along.no problem.

May 06 11:06 AM