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American Capital (NASDAQ:ACAS)

Q2 2014 Earnings Call

August 07, 2014 11:00 am ET

Executives

Pete Deoudes - Vice President of Investor Relations

Malon Wilkus - Founder, Chief Executive Officer, Chairman 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

Richard B. Shane - JP Morgan Chase & Co, Research Division

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

Jonathan Gerald Bock - Wells Fargo Securities, LLC, Research Division

Eric S. Stein - FSI Group, LLC

David Rothchild

Operator

Good day, everyone, and welcome to the American Capital, Ltd. Second Quarter 2014 Shareholder Call. [Operator Instructions] Please also note today's event is being recorded.

At this time, I'd like to 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 second quarter 2014 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 that 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 to by law.

An archive of this presentation will be available on our website, and the telephone recording can be accessed through August 20 by dialing (877) 344-7529. The replay passcode is 10049304. To view the Q2 slide presentation that corresponds with this call, please turn to our website at americancapital.com and please click on the Q2 2014 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 Wilkus.

Malon Wilkus

Thank you very much, Pete, and thanks, everyone, for joining us today for our earnings call. Before we go through the details of the quarter, I'd like to go over the second quarter highlights in a very busy first half of 2014 on Slide 3. In the second quarter, American Capital received over $400 million in cash proceeds from realizations, principally from the exits of SPL and Specialty Brands. Post quarter end, we also exited Tensar International Corporation and received $158 million in proceeds from its exit. In the second quarter, our leveraged finance group continued growing our investments in senior floating rate loans. As of quarter end, we had invested $579 million in senior floating rate loans and have since invested approximately $400 million in the third quarter to date. We intend to significantly increase this amount during the remaining portion of the quarter and the balance of the year. In Q2, our investments in senior floating rate loans contributed $4 million to operating revenue.

Moving to European Capital. It continued its strong distributions to American Capital with $34 million paid in the quarter and $138 million year-to-date. In the last 12 months, European Capital has distributed $333 million to American Capital and reduced to 0 its $98 million revolver from American Capital in the third quarter of 2013. Our dividend distributions from European Capital were treated as a reduction in American Capital's cost basis. Lastly, our investment in European Capital appreciated $60 million in the second quarter of 2014.

As discussed on our first quarter call, our asset management affiliate, American Capital Asset Management or ACAM, participated in the successful IPO in January 2014 of American Capital Senior Floating, which is trading on NASDAQ under the symbol ACSF. We believe this senior floating rate BDC managed by ACAM is an attractive vehicle for investors, particularly in a rising rate environment. With one of the lowest fee structures among BDCs and a very large market, we are optimistic that ACSF can grow like it's American Capital cousins, AGNC and MTGE.

On our last call, we announced that in April, we reached agreement with a group of investors that together with American Capital had committed $1.1 billion to American Capital Equity III. We call it ACE III, our fifth fund or company investing in private equity. This transaction further expands ACAM and diversifies our investor base, adding new private equity limited partners and increasing ACAM's earning assets under management by $0.9 billion or 7%. We expect ACE III to close later this quarter.

Post quarter end, we announced the closing of ACAS CLO 2014-1. This $619 million CLO has a 50-basis-point annual management fee. ACAM purchased 31 million of the non-rated equity tranche of subordinated notes, while third-party investors purchased the remaining 21 million of these notes. Collectively, in the 5 CLOs that ACAM manages, ACAM and American Capital own 120 million in non-rated equity tranches. ACAM now manages 3 public companies and 9 private funds. We continue to be very focused on growing ACAM and are making good progress adding new funds under management.

With respect to our balance sheet, as we announced on June 30, we obtained $750 million secured credit facility from Bank of America. The facility, which matures in June of 2016, bears interest at a rate of 1 month LIBOR plus 1.6% and allows us to appropriately lever our senior floating rate loans to realize an attractive cash ROE on the invested capital.

Now please turn to Slide 4. Last quarter, we made 2 announcements related to our efforts at evaluating our corporate structure to determine whether it and various legal regulatory and accounting regimes under which we operate are optimal for our business, and which we noted in our 2013 annual report on Form 10-K. First, in March, our board suspended our share repurchase and dividend program as it considers the capital requirements of any organizational changes that could result from this evaluation. And second, we announced the engagement of Goldman Sachs to assist us in evaluating separate -- separating our investment assets from our asset management business. Over the past 8 months, we have also conducted various internal studies and analysis and consulted with other external advisors. We've worked diligently and made good progress in evaluating, planning and preparing for the possible separation of our investment assets from our asset management business. Furthermore, as we exit investments, we have been reinvesting proceeds in attractive investments, including senior floating rate loans, which in particular could facilitate such a separation. However, as business development company with a diverse set of assets, separating our investments from our management business is quite complex. To implement this will require that we ensure compliance with the Investment Company Act, address a variety of tax issues, determine accounting and financial reporting requirements, consider the legal structure of a transaction in various filings, address the impact of separation on our portfolio companies, and we must develop governance, compliance and compensation arrangements. Despite this lengthy list and based on our progress, we hope to present our Board of Directors a specific proposal in the fourth quarter to complete such a transaction.

Now for the details on our performance in the second quarter, please turn to Slide 5. In the second quarter, our net asset value per share increased by $0.83 compared to the first quarter or 17% annualized to $20.12. We produced $0.15 of net operating income before income taxes per diluted share, which included a $0.07 per diluted share reduction from the net impact of debt and equity nonaccrual adjustments. The biggest impact on our net earnings for the quarter was the $101 million appreciation of ACAM and $60 million net appreciation of European Capital. Our net earnings totaled $0.76 per diluted share or $212 million, a 16% return on equity.

On Slide 6, we've already noted the strong realizations for the quarter and our new credit facility to fund senior floating rate loans. We also invested $234 million primarily in Sponsor Finance, Structured Products and ACAM.

So let's turn to Slide 7. We received $282 million from realizations in the second quarter from our operating companies. Our operating companies had modest aggregate revenue growth in Q2. However, they experienced a significant aggregate adjusted EBITDA decrease in Q2 year-over-year. This decrease in EBITDA, together with company specific issues, caused our operating companies to depreciate a net $15 million in Q2. Our portfolio company depreciated -- excuse me, I should say one portfolio company depreciated $35 million and was the significant driver of the EBITDA decrease. We have multiple teams working diligently with this portfolio company to improve its performance, and we have brought in an outstanding new CEO with tremendous industry experience. We continue to believe in the soundness of our original thesis for investing in the company, and we are guardedly optimistic the fruits of our efforts will be visible in the quarters ahead. Despite the slight depreciation and significant decline in EBITDA, our revenues from operating companies remained stable. We earned $51 million of interest dividend and fee income from operating companies in the second quarter versus $50 million in the first quarter.

Turning to Slide 8. Our second quarter realizations and originations from our sponsored finance investments were $41 million and $108 million, respectively. American Capital recognized no interest dividends and fee income from our sponsored finance companies in the second quarter due to the impact of nonaccrual adjustments. Non-including the impact of nonaccruing loans, we earned $16 million of the interest dividends and fee income in Q2 versus $19 million in the first quarter of 2014 from our sponsored finance investments.

As a reminder, a portion of the increase in nonaccruing assets is caused by asset values rising at a slower pace than the contractual obligations for paid in kind interest and preferred dividends arising. We continue to receive payments on many nonaccrual loans, and we are optimistic that we will recover more value from these loans over time. We saw a moderate aggregate revenue and adjusted EBITDA increases in Q2 year-over-year for our Sponsor Finance companies. The increase in adjusted EBITDA contributed to the $18 million of net appreciation of these investments in the second quarter.

Let me now pass the call over to John Erickson to discuss senior floating rate loans, ACAM and ACE III.

John R. Erickson

Thanks, Malon. Please turn to Slide 9. To better utilize our unlevered balance sheet and to reposition our balance sheet to prepare for the possible separation of our investment assets from our management business, we have begun making investments in senior floating rate loans, now totaling $768 million. We expect to make further investments in the coming quarters.

For Slides 10 and 11, I would highlight that we invested another $50 million in ACAM to incubate additional CLOs that we will manage. Also ACAM appreciated by $101 million during the quarter, driven by the strong performance and preferred equity issuances of our 2 mortgage REITs, AGNC and MTGE.

I'll skip over the details of ACE III on the Slides 12 and 13, which we covered last quarter and just reiterate that we expect ACE III to close during the third quarter of this year.

With that, let's turn to Slide 14, and let me turn the call over to Ira to discuss European Capital.

Ira J. Wagner

Thanks, John. While realizations of new investing at European Capital were minimal in the second quarter, it did have net earnings for the quarter totaling $49 million, which was a 29% annualized net earnings return on equity. In fact, since 2009, European Capital has produced an annualized net earnings return on equity of 13%. European Capital's portfolio companies continue to perform, producing significant aggregate revenue and adjusted EBITDA increases in the past 3 months year-over-year. This performance produced a EUR 49 million or 29% annualized increase in the NAV in the second quarter at European Capital, prior to its EUR 25 million dividend distribution to American Capital, which equals $34 million.

Continuing on to Slide 15. In the second quarter, our investment in European Capital continued to perform well, appreciating a net $60 million. At the end of the quarter, we had $827 million invested in European Capital at fair market value, which is a 13% discount to European Capital's NAV. The NAV of which includes $11 million of bond yield discount on performing loans. This 13% discount of European Capital's NAV was flat from the first quarter.

With that, I'll hand the call back to Malon.

Malon Wilkus

Thanks, Ira. Please, everyone, move to Slide 16, where you can see that we invested $73 million in the second quarter in Structured Products, of which $71 million was invested in CLO equity. Our structured products investments produced $20 million of interest income in the second quarter versus $12 million in the first quarter of this year. For the quarter, these investments appreciated $3 million.

I'll pause a second on Slide 17, a familiar slide to many of you, to point out that we've added the possible separation of our investment assets from our asset management business as another potential way in which we might grow shareholder value per share. I'll skip our outlook -- excuse me, I'll skip our outlook slide, which you can review on your own and settle on Slide 19, which highlights the 13% annualized growth in our net asset value per share from the second quarter, and the 22% annualized growth rate since 2009. While you review these -- this slide, let me turn the call back to Pete so we can open up for the questions.

Pete Deoudes

Jamie, if you can please open up the call for questions, please?

Question-and-Answer Session

Operator

[Operator Instructions] And our first question today comes from Rick Shane from JPMorgan.

Richard B. Shane - JP Morgan Chase & Co, Research Division

Just one quick question. Obviously, there -- you guys are working extensively related to the separation. One thing that surprises us is that we haven't seen any coincidental pickup in operating expenses associated with this. It's that something we should be looking forward -- looking to going forward? Or how is this being expensed currently?

John R. Erickson

Rick, I think being that we are in the financial service business, we're doing a lot of this stuff internally. So we don't expect to have to rely as significantly on advisors as maybe a manufacturing company was going through its transformative type of transaction. So really we have a lot of internal resources, so a lot of the tax analysis, a lot of the GAAP and so forth stuff that we're doing is really being done by internal people. And so we are using advisors, but it's not anything that I would expect to have a significant or material impact on our expenses.

Richard B. Shane - JP Morgan Chase & Co, Research Division

Great. One last question. Related to the ACE III transaction, there's no cash out that you get from that transaction, is there?

John R. Erickson

Yes, I mean, we are selling our equity stakes. So the equity stakes we currently own that are going into ACE III will generate cash proceeds to American Capital when we close this transaction.

Malon Wilkus

Now net of the $200 million in which we -- that we will be committing actually to new investments over time through the primary component of that ACE III fund.

Richard B. Shane - JP Morgan Chase & Co, Research Division

So you will get cash out and then contribute into ACE III? And the way to think about the cash out is on a net basis?

Malon Wilkus

Well, no. I would say the cash outcomes and then over time as investments are made, our $200 million commitment will get drawn.

John R. Erickson

Right. I mean, a typical private equity investment period would be multiple years. So 3 years, 4 years, whatever your assumptions are, but the $200 million is going to be spent over time as they find good investments.

Operator

Our next question comes from Greg Mason from KBW.

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

Great. To follow-up on Rick Shane's question, just on the capital requirements you suspended the share repurchase. You had a lot of repayment activity in the second quarter that's going to continue in 3Q with the closing of ACE III. Is there a point of capital return where you would consider resuming the share buyback?

John R. Erickson

One of the things is an asset manager is if where -- as we continue to pursue that strategy, the more capital we have under management is actually accretive. So if you look at the share repurchases and at the discount to NAV and then you turn around and assume that we retain that capital and put a management fee structure on it, that actually becomes very accretive. So we think that in the direction we're heading, we actually can invest that capital at attractive rates of return and retain it so that we've a larger fee stream, fee asset manager and a bigger pool of capital to potentially distribute out to the shareholders.

Malon Wilkus

And let me also add that to pursue a separation, there's a variety of uses for that capital that's going to be important to make it feasible to do a separation, and -- such as buying in the senior third-party depth of existing controlled companies, investing in more of our capital into the senior floating rate notes where we don't have control features and so on and so forth. So those -- that -- the retained earnings that we are keeping and not using as part of the buyback program is actually facilitating our ability to be able to consider a separation of our investment assets from our asset management company.

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

Okay, great. And then one more question, if I may. In Slide 4, there was a lengthy list of things that need to be accomplished if the board approves the restructuring. Is that an attempt to send a message that this is still going to be a lengthy process even after the board approves for the restructuring to be consummated? Or is that just legalese? Or how should we think about that?

Malon Wilkus

Look, this is -- we are fairly complicated company and we're particularly as being subject to the 40-App, it makes a separation of the type that we're considering very complicated, and indeed, it will take time. It will take more time than other companies that have gone through corporate restructurings that aren't really as complicated or subject to the kind of regulatory environment that we are. And indeed, I think one of our objectives of putting this information out is to help people understand the complexity. And I think this probably does a decent job.

John R. Erickson

Because I think at first blush, an investor that's not that familiar with us would say why don't you just spin the asset manager out, just a one step process. And I think we're trying to highlight while that might be the fastest way to do it, there's actually a lot of other complex considerations that we got to think through.

Operator

[Operator Instructions] Our next question comes from Jon Bock from Wells Fargo Securities.

Jonathan Gerald Bock - Wells Fargo Securities, LLC, Research Division

Malon, as we see the liquid levered loans being added to the balance sheet today to effectuate the spend, just curious on the yield at which you're putting on, because you have a very similar BDC in American Capital Senior Floating, that's putting on liquid levered loan collateral at coupons in the 5% plus range. Yes, I think we see the weighted average yield here in the mid-4s. Can you walk us through the delta and whether or not one would be considering maybe moving up the yield spectrum and making additional investments?

Malon Wilkus

Yes, I believe the statistics that you're thinking off from American Capital Senior Floating, the BDC that we manage to invest in senior floating rate loans, those statistics include both first and second lien, and we have been concentrating, at least initially, on first lien investments. And so the yield is a little bit lower.

John R. Erickson

Also, we've been more focused on a bit more liquid collateral, which means probably a little bit higher rated than what we're doing. And the other thing is primary or new issue versus secondary trades. And so in order to build the portfolio, we're more oriented towards secondary traits. So you would drive some yield differences.

Jonathan Gerald Bock - Wells Fargo Securities, LLC, Research Division

Got it, okay. I appreciate that. And then as we look at kind of a global -- more global question as it relates to not only the attractiveness of ACAM, but the attractiveness of the LPs that are going to be out there, and by the LP, I mean, the externally managed BDCs. So can you give us a sense of the push-pull dynamic here? The more you charge those LPs, the higher the value of ACAM, but the lower the value of the LPs, because their ROE becomes compressed. So it would be helpful to understand maybe how you're kind of looking at that dynamic, because in some cases, charge too much, ROEs are low, price-to-book value on LPs trades down, which we all loan, and not charge enough growth that the asset manager might not be as attractive as maybe people are modeling. So just get your sense there between the push-pull dynamic.

Malon Wilkus

Look, in thinking about how we might separate our investments from the asset management company, we do think about the final vehicle and/or multiple vehicles that the investments may end up in and that those vehicles need to be structured to be highly acceptable by the marketplace and consistent with the peers that they will be compared to. And so it's important that -- and so when you think about it, you should be thinking about what the peers look like. Now we've spent a lot of time thinking and thinking through this and we think it's feasible to be able to structure some vehicles that indeed would, in some cases, be quite similar to their peers.

Operator

Our next question comes from Eric Stein from FSI Group.

Eric S. Stein - FSI Group, LLC

I just had a question for you on potential spin out as well. Over the last few months, you've been obviously transforming the balance sheet as if you're going to do this, and thinking back to maybe just from previous comments, you've always said that the share buyback was a better use of dividend when you're trading below NAV. But listening to the comments on the call, it seems like you guys are actually committed to -- or management was committed to doing this. You just sort of comment on, is this the change of business strategy going forward? I know you've just go through the board approval, but like I said, just reading the tea leaves it sounds like that something that management wants to pursue.

Malon Wilkus

Yes, I think it's pretty apparent that our comments in both the release and here today is that management has done a lot of work and we believe that, that is appropriate to present our board with a proposal to separate the investments from the asset management company. And that is a change. We've done a lot of work. And prior to doing that work, we wouldn't be prepared to point that out. Now there's still a lot more work to be done. So things can change, and indeed, our board will have to consider that additional work and the work we've done to date and making its decision. And of course, we will keep the market posted on what decisions we make.

Operator

And our final question today comes from David Rothchild from Raymond James.

David Rothchild

Yes, trying to pin you guys down a little bit on the spin-off. Do you think it's going to be done with by year end?

Malon Wilkus

Yes, first of all, we should reiterate that our board has to make a decision about this, and they certainly haven't made that decision as of yet. But I will tell you, if we make the proposal to the board as we intend to, if our board decides to do this, there is no way it could be done by the end of the year. I just think it's just inconceivable to do it by the end of the year. And if you look on Slide 4, the kind of issues that we have to grapple with to be able to implement it, I do want to convey that this is a very complex -- we are complex today and the transaction would be complex if we were to do it. And so it will take time to be in a position to be able to implement it. And by the way, let me just say that one element of this process is proxy statements that would go to the SEC and the SEC would no doubt take a substantial amount of time reviewing it. It's very common and I think in this more complex situation that we're in, subject to the 40-APP as we are, we would expect that review to be longer than you would see in other circumstances.

David Rothchild

Okay. The other question I had is on these floating rate funds where you're investing at 4.4%. I would think that your traditional BDC type of loans where you're getting 9%, 10%, 11%, 12% would be better for your investors. Can you explain to me why a 4.4% return is better?

Malon Wilkus

Let me just say, in today's market, the kind of risk-reward profile that we see in the mezzanine and second lien lending opportunity is not nearly as attractive as it used to be, number one. Number two is the senior floating rate loans we think are really an outstanding risk-reward profile even today even though rates and yields have come in over the last several years. Nonetheless, we think it's still outstanding. And one thing that's quite different about those assets is that you can borrow against them and you can lever them. And as you know, we have a very unlevered balance sheet today, and we can apply all of the leverage capability of our balance sheet, which is one-to-one debt-to-equity, but we could apply it all to these assets. And we haven't done that yet, but you will see -- you've just seen that we've announced earlier this quarter and we've noted it in this presentation that we've entered into a new credit facility, $750 million credit facility. And as we start making use of that credit facility, we are going to be causing a return on our equity invested in this sector of these assets to repay, what we would consider, a fine return, and particularly a fine risk-adjusted return. So number one, we're investing some of our cash that we haven't otherwise had well invested, we're investing that in these assets; and then number two, we'll start drawing on our credit facility to produce a marginal spread of income to our equity. And together with those 2 things, we think we'll produce a good return that will contribute to improving -- relatively speaking, improving our net operating income.

David Rothchild

What's your average cost of debt for the corporation?

John R. Erickson

Well, the cost against the senior loans is about L plus 1.60. So senior loans get a lower cost of funding than some of our other assets.

Operator

Ladies and gentlemen, we have now completed the question-and-answer session. At this time, I'd like to turn the conference call back to Malon Wilkus for any closing remarks.

Malon Wilkus

Thank you very much, Jamie, and thanks, everyone, for joining us today. We appreciate your questions, and we look forward to talking to you again next quarter.

Operator

Ladies and gentlemen, the conference has now concluded. An archive of this presentation will be available on ACAS's website, and a telephone recording of this call can be accessed through August 20 by dialing (877) 344-7529, using the conference ID 10049304. We thank you for joining today's conference call. You may now disconnect your telephone lines.

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Source: American Capital's (ACAS) CEO Malon Wilkus on Q2 2014 Results - Earnings Call Transcript

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