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American Capital (NASDAQ:ACAS)

Q4 2013 Earnings Call

February 11, 2014 11:00 am ET

Executives

Pete Deoudes - Vice President of Investor Relations

Malon Wilkus - Founder, Chairman, Chief Executive Officer and Chairman of Executive Committee

John R. Erickson - Chief Financial Officer, Principal Accounting Officer, President of Structured Finance, and Member of Investment Committee

Ira J. Wagner - President of European Private Finance

Analysts

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

Kyle M. Joseph - Stephens Inc., Research Division

Eric S. Stein - FSI Group, LLC

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Operator

Good morning, everyone, and welcome to the American Capital Q4 2013 Shareholder Conference Call. [Operator Instructions] Please also note, today's event is being recorded. At this time, I would like to turn the conference call over to Mr. Pete Deoudes in Investor Relations. Sir, please go ahead.

Pete Deoudes

Thank you, Jamie, and thank you, everyone, for joining American Capital's Fourth Quarter 2013 Earnings Call.

Before we begin the call, I'd like to review the Safe Harbor statement. This conference call and corresponding slide presentation contain statements that, to the extent they are not recitations of historical fact, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of American Capital.

All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in our periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC's website at www.sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law. An archive of this presentation will be available on our website, and the telephone recording can be accessed through 9:00 a.m. on February 25 by dialing (877) 344-7529. The replay passcode is 10039554.

To view the Q4 slide presentation that corresponds with this call, turn to our website at americancapital.com and click on the Q4 2013 Earnings Presentation link in the upper right-hand corner of the homepage. Please select the webcast option for both slides and audio, or click on the link in the conference call section to view the streaming slide presentation during the call.

Participating on today's call are Malon Wilkus, Chairman and Chief Executive Officer; John Erickson, President, Structured Finance, and Chief Financial Officer; Gordon O'Brien, President, Specialty Finance and Operations; Ira Wagner, President, European Private Finance; Sam Flax, Executive Vice President and General Counsel; and Rich Konzmann, Senior Vice President, Accounting and Reporting.

With that, I'll turn the call over to Malon.

Malon Wilkus

Thanks, Pete, and thank you, everyone, for taking the time to join us today. Please turn to Slide 3.

In 2013, we modestly increased our book value per share by 6% despite the headwinds of a decrease in the value of our Asset Management business, ACAM, and our operating companies. However, we made important progress in each of our business lines during the year, which helps us position us for better performance in 2014.

Our private finance business in the U.S. experienced significant realizations in 2013, in line with recent years, and achieved exit values consistent with our prior quarter's determination of fair value. We also made attractive new investments in several One Stop Buyouts and Sponsor Finance opportunities in a highly competitive environment. We also introduced a new strategy in the fourth quarter of retaining senior debt in our One Stop Buyouts, which we believe will increase NOI and transparency and demonstrate the earnings power of our operating companies over time.

In Europe, we exited a considerable number of investments, realizing substantial liquidity consistent with our prior quarter's determination of fair value. We used this liquidity to pay down debt, allowing us the freedom to repatriate capital to American Capital even as we actively made new debt investments.

At American Capital Asset Management, despite the decrease in book value of our 2 REITs under management, we maintained the amount of earning assets under management that we had at the end of 2012, and revenue from ACAM increased since, during most of 2013, the amount of our earning assets under management was materially higher than during 2012.

We also raised 2 new CLOs and prepared for the IPO of American Capital Senior Floating, which succeeded in going public in early 20 -- in early January 2014 and is now trading on NASDAQ under the symbol ACSF. We believe the mortgage REIT environment has stabilized and are guardedly optimistic that ACAM can return to growth in 2014. And we have other fund strategies in the works at ACAM, and we would expect some of them to come to fruition in 2014.

As we discussed in detail last quarter, with our goal to return to investment grade, we further solidified the right side of our balance sheet, refinancing our secured facility, tapping the unsecured market, repaying our last on-balance sheet securitization while expanding and extending our stock repurchase program.

As you may have seen in the release earlier this morning, we are again refinancing our secured facility.

Now for the details. Please turn to Slide 4. Net asset value grew $1.13 per share to $18.97, increasing 6% for the year. We produced a $0.76 net operating income before taxes per diluted share, or $232 million, a 4% return on equity. Net appreciation at European Capital offset net depreciation in all other business lines, so our net earnings totaled $0.61 per diluted share or $184 million, a 3% return on equity.

Continuing on Slide 5, we had $1.2 billion in realizations, not including $98 million of net repayment of European Capital's revolving credit facility. We committed $1.1 billion to 2 -- to new investments, including $271 million in investments in ACAM for fund development, which we believe will generate attractive returns for our shareholders and help us develop new funds. Additionally, our stock repurchase and dividend program continues to be highly accretive and an important enhancement to shareholder value. We repurchased 40 million shares for $561 million at an average price of $13.90 per share, producing $0.66 in accretion to NAV per share.

Turning to Slide 6. In the fourth quarter, our net asset value decreased $0.57, or negative 12% annualized. We produced $0.19 of net operating income before income taxes per diluted share, including a $0.05 per share reduction from the net impact of debt and equity nonaccrual adjustments. The biggest impact on our net earnings for the quarter was the significant depreciation at ACAM and operating companies, which was partially offset by European Capital net appreciation. This resulted in a $0.66 net loss per diluted share.

Continuing with the fourth quarter, on Slide 7, we had $559 million of realizations, including $158 million in cash distributions from European Capital. We made $897 million of investment commitments in the quarter, including $240 million of investments in ACAM for fund development and $391 million for the One Stop Buyout of AAIPharma and its merger with and recapitalization of our operating company, CML. Finally, we had $0.13 per share of accretion due to our stock repurchases in the fourth quarter.

Skipping over Slide 8, which graphically shows our 23% annual growth rate in NAV per share since 2009, let's turn to Slide 9 to review our operating companies.

We believe we made attractive new One Stop Buyouts in 2013 which benefit shareholders, such as Service Experts and CML-AAIPharma under our new One Stop Buyout strategy. In 2013, we received $530 million from realizations from 34 of our operating companies, $141 million in the fourth quarter. We also committed $503 million to new investments in operating companies in 2013, $454 million of which was committed in Q4. Most of this amount, $391 million, was for the One Stop Buyout of AAIPharma and its merger with and recapitalization of our operating company, CML, which we spoke about last quarter and which is also detailed on Slide 10.

We believe that with our new One Stop Buyout strategy in place, we will increase our net operating income and provide more transparency into our operating companies over time. Our Syndications Team syndicated $1.1 billion of loans at our operating companies to third-party lenders in 2013, generally improving their cost of capital and, in some cases, allowing for dividend recapitalizations.

American Capital earned $145 million of interest, dividend and fee income in 2013 from our operating companies. $38 million of that was in the fourth quarter. Our operating companies had moderate aggregate revenue growth in the fourth quarter. However, they experienced a slight aggregate adjusted EBITDA decrease in the quarter. This decrease in EBITDA, together with company-specific issues and combined with the fact that multiples in private companies did not expand as they did in public companies during the year, caused our operating companies to depreciate a net $102 million in 2013, all of it coming in the fourth quarter, totaling a net $136 million.

The 5 companies with the largest amount of depreciation in the quarter ranged from $15 million to $39 million of depreciation. Two of these are valued above their cost. We are working hard to translate revenue increases into greater earnings and resolve company-specific issues.

I'll skip over Slides 10 and 11, which detail the One Stop Buyout of the AAIPharma and Service Experts, respectively, as well as Slide 12, which details our new One Stop Buyout strategy presented in the third quarter.

Turning to Slide 13. We were quite pleased with our fourth quarter Sponsor Finance and Direct originations of $176 million, $258 million in 20 -- in all of 2013 since, as you know, we are cautiously investing in the current competitive environment. During the year, half of our investments were in 8 new portfolio companies and half in 8 existing portfolio companies.

American Capital recognized $131 million of interest, dividends and fee income from our Sponsor Finance companies in 2013, $33 million of that in the fourth quarter. We saw modest aggregate revenue and adjusted EBITDA increase in Q4 year-over-year for our Sponsor Finance companies.

Turning to Slide 14. I'll have John review American Capital Asset Management.

John R. Erickson

Thank you. Thank you, Malon. We are excited about American Capital Asset Management's further diversification during the year and potential for growth. ACAM ended the year with $12.7 billion of earning assets under management, which was up $300 million compared to the end of 2012 but down $1.5 billion from Q3. The quarterly decline was due to the reduction of earning AUM in our mortgage REITs.

AGNC and MTGE suffered with the mortgage market selloff during the period but continued to perform well relative to their peers. MTGE acquired a licensed mortgage servicer in Q4, which will expand MTGE's opportunities. We believe the mortgage market has stabilized, which should bode well for our mortgage REITs. With the successful track record of our leveraged finance group REIT, we raised 2 CLOs and the incubated American Capital Senior Floating, which we succeeded in taking public in January.

We believe this senior floating rate BDC is an attractive vehicle for investors, particularly in a rising rate environment. ACAM is managing ACSF at what we believe is a very investor-friendly fee structure of 80 bps on total assets with no carried interest.

We invested $271 million in ACAM for fund development in 2013, including $189 million to incubate ACSF, which was repaid upon the IPO.

Turning to Slide 15. American Capital earned $133 million of dividend, fee and interest income in ACAM in 2013, a 29% increase over 2012.

The increase was a result of our average earning assets under management during the year being materially higher than during 2012. We expect a lower level of income in 2014 due to share repurchases and realized losses at the mortgage REITs, which contributed to the $185 million depreciation ACAM experienced during the quarter.

While the mortgage REIT market has been challenging, we've been working on further diversifying the funds and companies we manage. We have other managed vehicles in the works, some of which we expect to raise in 2014. That fact, coupled with our belief that the mortgage REIT market has stabilized, makes us guardedly optimistic that we can grow ACAM during 2014.

Turning to Slide 16. Let me turn the call over to Ira to review European Capital.

Ira J. Wagner

Thanks, John. European Capital received EUR 586 million of realizations in 2013, which allowed European Capital to repay its debt by EUR 324 million and also allowed European Capital to repatriate capital to American Capital. It repaid EUR 115 million on its -- $150 million on its revolver, which included PIK interest, and paid a dividend of $178 million to American Capital, a total of $293 million for the year. European Capital also committed EUR 80 million to new investments in 2013, predominantly in new debt investments.

European Capital earned EUR 44 million of net operating income in 2013, EUR 11 million in the fourth quarter, a 6% NOI return on equity in 2013 and 6% in the fourth quarter. European Capital's net earnings for the year totaled EUR 144 million, EUR 23 million in the fourth quarter, or 10% net earnings ROE in 2013 and 12% in the quarter.

European Capital portfolio companies had a modest aggregate revenue increase and a moderate adjusted EBITDA increase in the past 3 months year-over-year. And finally, European Capital produced a EUR 144 million increase in net operating value in 2013 prior to its dividend distributions to American Capital, EUR 23 million of which came in the fourth quarter. That's a 20% for the year and an 11% annualized increase in the fourth quarter.

I'll skip over Slide 17, which details European Capital's 13% annual growth in NAV since 2009, including the dividend distributions.

Continuing on to Slide 18. We can skip the first diamond, which was covered on the prior slide concerning ECAS' repayment of ACAS debt and its dividend payment.

In 2013, American Capital's investment in European Capital performed well, appreciating $316 million, $115 million of which in the fourth quarter, of which $35 million was due to foreign currency translation, $13 million of which in the fourth quarter. This was a 25% return on the fair value of our equity investment in European Capital for 2013.

At the end of 2013, we had $841 million invested in European Capital at fair value, which is a 15% discount to ECAS' NAV, the NAV of which includes $39 million of bond yield discount on performing loans. This 15% discount of ECAS' NAV was an improvement from the 20% discount at the end of Q3 and a 25% discount at the end of 2012.

The improvement in Q4 of the discount to NAV was driven primarily by improved performance and liquidity at European Capital.

Please turn to Slide 19, where we review our Structured Products, while I pass this back to Malon to finish our presentation.

Malon Wilkus

Thank you, Ira. On Slide 19, you can see that we invested $75 million in 2013, $27 million in the fourth quarter, in Structured Products, of which $70 million was invested in CLOs.

Our Structured Products investments produced $72 million in interest in the year, $13 million in the fourth quarter. However, many of our CLO equity investments are maturing and we'll likely repay entirely within the next several years. This may cause our Structured Products revenue to decline, offset to the extent to which we make new investments in CLO equity.

Our Structured Products depreciated $41 million in the year, $14 million in the fourth quarter, little of which was due to declining credit quality.

I won't go over the details of our 2013 balance sheet financing update on Slide 20, since we reviewed that before, nor will I review the drivers for growth and the stock repurchase and dividend program on Slides 21 and 22.

So we will end on Slide 23 and let you review our outlook yourself as I turn the call back to Pete so he can open the call for questions.

Pete Deoudes

Thanks, Malon. Jamie, can you please start the Q&A?

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Greg Mason from KBW.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

First, I wanted to see if you could give us a little additional color on the credit movements. I know nonaccruals went down slightly in the quarter, but you also had $74 million of debt-to-equity conversions. So could you tell us how many of those loans were on nonaccrual last quarter? And just, why the jump in credit issues in what seems to be a very benign credit environment? Just any additional color you can give on the credit quality in the portfolio.

John R. Erickson

Yes, I think there was one credit moved back on nonaccrual that was in a company that has been a little bit weak. It's been on nonaccrual previously. It went off, and we put it back on nonaccrual this quarter. It was just a slight amount of value below the security. And I think that, as you're aware, we've got a lot of junior securities in the capital structure that have PIK features. And sometimes, what happens is the PIK builds up, and then the enterprise value doesn't quite cover it, and we like to put it on nonaccrual. So I don't think there's any really negative trend in the portfolio that's -- you're right, we wrote some things off, and then we had a couple go back onto nonaccrual. But it's a credit that I think that we'll ultimately get paid in, but the value rate right now is somewhere in the accrued PIK.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

Okay, great. And then, you touched a little bit on the Structured Products income falling as those roll off, but it's been running around $20 million of revenue per quarter the last few quarters, and it fell to $13 million this quarter. Are there any moving parts that lowered this level? And is this a new run rate here at $13 million or just a temporary decline?

John R. Erickson

Yes, that's probably a good run rate right now is where we're at. And I think, as you note some of these vehicles -- obviously, these were invested in '05 to '07, and so you could expect they're going to get called out at some point. And so that will shrink the income off of that portfolio, but at the same time, we are making new investments, and you'll see those going onto the books in Structured Products that, hopefully, will offset some of that.

Malon Wilkus

And you can see some of those, the new investments for the 2013 totaled $75 million.

Operator

Our next question comes from Kyle Joseph from Stephens.

Kyle M. Joseph - Stephens Inc., Research Division

So historically, we've seen NAV changes have been correlated to GDP. In the fourth quarter, that didn't seem to be the case. In your minds, is this sort of a one-off quarter, or has the relationship or correlation changed in your minds?

Malon Wilkus

Well, certainly, in all of 2013, whereas the S&P, the Russell, all of those multiples increased quite materially for the year, and even for the fourth quarter, for all of 2013, the private company multiples increased just a fraction and, for the fourth quarter, declined a fraction. And so, for instance, one of the companies that -- where we booked a substantial amount of depreciation for the quarter had a decline of 0.2% on its multiple, causing half of the decline of the depreciation associated with that company. And the other portion of it was associated with a decline, a 5% decline for the quarter of its EBITDA. And we think this is a great company. We think it has a great potential for further growth and performance and see -- saw this, the second largest of our depreciations for the quarter, as a quarterly fluctuation.

John R. Erickson

And also, I think European Capital is moving in the right direction with respect to valuation. And then, as I discussed with ACAM, obviously, the mortgage REIT space was very tough this year, and we took some hits there. But we do believe that, that has stabilized. And so I think we're optimistic, or guardedly optimistic, that we can grow ACAM in 2014, given some of the other fund efforts we have in the works. So hopefully, that will also help for the NAV growth.

Kyle M. Joseph - Stephens Inc., Research Division

Okay. And I'll follow up with a -- I just want to have a little better understanding of yield movements in the quarter. The portfolio yield appeared to come in quite a bit. Is that just where you're able to originate new assets, or is any of that tied to the new One Stop Buyout strategy and no longer syndicating senior debt?

Malon Wilkus

Actually, all 3 is the case. So we originated a substantial amount of Sponsor Finance investments for the year and -- totaling -- it was $258 million. And those would be at lower yields than what we had on our portfolio for the balance of it. And number two, we did also, as we pointed out, we -- when we financed AAIPharma and we refinanced all of CML and took out the third-party senior there and essentially funded that senior at senior rates.

John R. Erickson

We funded $288 million in CML at 8%, so that would bring the overall portfolio yield down.

Malon Wilkus

Yes. So all 3 of those things are occurring.

Operator

Our next question comes from Angelo Guarino [ph] from DTI [ph].

Unknown Analyst

First question is, in October, you -- in your 40-APP filing, you had talked about 3 new funds that you were looking to roll out -- you proposed to manage. One was an AC Energy, basically, fund. One was going to be what looks like an ACE III fund. And the third one was going to be a public entity, which was going to be -- you called BDC loan. Can we think of the new IPO as being what you were referring to as BDC loan?

Malon Wilkus

Yes.

Unknown Analyst

Okay, good. And the other one has to do with...

Malon Wilkus

And I'll also point out that, in the year, in the fourth quarter, we have started to make investments in our global energy and infrastructure team. We've now made 3 commitments and investments in companies around the world in the arena of energy, one in -- one that would support a windmill farm; second, a gas-fired -- natural gas-fired energy plant, electrical plant; and the third, a hydroelectric plant. So we're very pleased. We like the diversification. We like the kind of transactions that we're seeing there. And Paul and his team are doing a great job.

Unknown Analyst

So in -- you're building up that portfolio, but I guess, as you kind of described in that filing, is that you hope to invest approximately $200 million in a private fund at some point. So you're still in the building phase, and the rollout of that private fund hasn't occurred yet?

Malon Wilkus

That's correct. Our -- so our investments that I just referred to is part of that $200 million that we have internally kind of committed to, to that effort, and we hope to be able to attract third-party capital to that and quite excited about it.

John R. Erickson

And those investments sit on ACAS' balance sheet currently.

Malon Wilkus

So, by the way, the investments that we made into ACAM that we pointed out in our comments earlier for fund development, there's actually even more investments beyond that, which we are making for fund development, such as those for the energy and infrastructure team.

Unknown Analyst

And the ACE III is basically -- hasn't happened yet? I didn't miss anything on that, right?

Malon Wilkus

There is no information, no news on ACE III.

Unknown Analyst

The other question I had is kind of a philosophical question. Maybe the result of -- about when you decide something is material. There was a press release from a Chinese company about, basically, a tangible agreement to buy your third largest asset as of the last quarter, Scientific Protein Labs. And there was really nothing out of you about that. When do you -- that I saw. When do you all think that, that's -- either that's incorrect, the news was incorrect, or there's -- you basically don't find that material enough to talk about?

Malon Wilkus

Our experience is transactions don't close until they do. And you can never be absolutely certain about a transaction. So our policy that we've followed for 17 years has been that we do a press release upon the closing and funding of a transaction, not the entering into of agreements, which are still subject to lots of pre-closing requirements. So...

Unknown Analyst

And that one in particular has some high hurdles, I assume?

Malon Wilkus

There are certain hurdles associated with a company like SPL. A transaction like you're describing probably would require both Chinese approvals as well as certain U.S. approvals before it could be done.

Unknown Analyst

And is considerable portions of Scientific Protein is in the ACEs, ACE I and ACE II?

Malon Wilkus

We will -- I think it's just in ACE I and not in ACE II.

Operator

[Operator Instructions] And our next question comes from Eric Stein from FSI Group.

Eric S. Stein - FSI Group, LLC

I had a question for you on ACAM. You guys have been trading below NAV for a little bit now, and it seems to us -- or my view is the ACAM is marked conservatively. Would you ever look at spinning that out to see if you get a higher multiple in the public markets?

Malon Wilkus

You're referring to ACAM. And, certainly, we've seen some recent transactions in asset managers, which we find to be very interesting and informative. We've followed, of course, the alternative asset managers for many years. We view ourselves as, in part, an alternative asset manager. And they have actually been trading better and better over the years, I think, as the market has become more familiar with them. And we like that a lot and think that, that possibly presents an opportunity for us. It's extremely -- it's safe. It's something that we're extremely interested in and paying a great deal of attention to.

Operator

And our final question comes from Jonathan Bock from Wells Fargo.

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Maybe dovetailing off the last question as it relates to spinouts, as we know that there is a comp in the form of NRF. Whether it's extremely comparable or not can be debated, but it's a comp nonetheless. Malon, if -- it would seem to make a lot of sense that a One Stop Buyout-focused BDC, which ACAS is currently kind of is, as those cash flows get dividended out, make a lot of sense. However, in order for that to happen, one would need to effectively purchase some amount of debt assets in order to make sure one is in compliance with RIC rules, et cetera. And so a question would be, how much debt would need to be purchased in order to effectively return ACAS to RIC-compliant status, kind of rough numbers if there is one out there, if you've maybe even thought about it?

Malon Wilkus

Yes, about 65% of our assets are controlled companies. And the rule is that you have to have no more than 50% of your assets in where you have more than 10% ownership to qualify as a RIC under the tax code. And so I think that's what you're kind of talking about. And so, right now, it would be a -- it would be many billions of dollars of additional noncontrolled assets that we would have to have on our balance sheet to qualify as a RIC.

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Okay, great. And then maybe one other question is, as people kind of think of the mechanics, if there were a spinout to occur, is it possible that the tax loss carries with ACAS or ACAM, the asset manager, in a spinout scenario?

John R. Erickson

Yes, I think that you -- that would be the scenario you would be looking for because the assets that would go into a RIC-BDC, you would want them to be dividend-paying. And so, having a tax loss in that vehicle wouldn't make sense, so you would want to have the tax loss be in the asset management vehicle [ph].

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Okay. So, in effect, it is transferable, or it could be applied to the ACAM spinout, I guess, is just the question?

John R. Erickson

No. I wouldn't say it that way. I would say that the better way to think of it would be that you would spin out the BDC and leave the asset manager at ACAS. And ACAS really transforms itself to ACAM.

Pete Deoudes

I just wanted to -- this is Pete. I wanted to make one correction before turning the call over to Malon to say thank you. For Angelo's [ph] question, SPL is in both ACE I and ACE II. Malon?

Malon Wilkus

Thanks, Pete. And thanks, everybody, for joining us on this call. We look forward to talking to you next quarter. We -- I have to say, we feel like this could be an excellent year for us, and we appreciate you all attending. Goodbye now.

Operator

To access the digital replay of this conference, you may dial 1 (877) 344-7529 or 1 (412) 317-0088 beginning at 2:00 p.m. Eastern Time today. You will be prompted to enter a conference number, which will be 10039554. You'll be prompted to record your name and company when joining. Today's conference has now concluded. We do thank you for joining today's presentation. You may now disconnect your telephone lines.

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