American Capital Ltd. (ACAS) has seen a bit of a run-up in share price recently ahead of its Valentines Day earnings report. Some of the reasons for optimism consist of recent news. One additional reason is the movement of the broader stock market in the recent past. These factors provide reason for conviction that on Valentine's Day, management will show evidence of their devout attention to the interests of their patient shareholders.
Managing Others' Money
Two publicly-traded investment funds managed by American Capital have just released earnings reports of their own. The first, American Capital Agency Corp. (AGNC), announced that its 4Q2011 produced an economic return that annualized to 33%, including not only a fat dividend but net asset value per share growth of 81¢ over the quarter to $27.71. In reaction, shares surged past $30 to trade at a premium to NAV of nearly 9%. The second, American Capital Mortgage Investment Corp. (MTGE), announced the results of its first-ever full quarter of operations, about which this article was published. That first full quarter of operations, reflecting net income of $1.72, took NAV over its August IPO price. On a NAV that opened the quarter less than $20, this heart-warming result annualizes to a 34% economic return. On this news, American Capital Mortgage Investment's share prices moved upward, trading for the first time at least briefly at a premium to the last-published NAV. At the time of this writing, the last-traded price of American Capital's newest publicly-traded managed fund was above $21, and at a premium to American Capital Mortgage Investment's last-published NAV of $20.87 (and much better than the under-$17 the shares faced when its performance sat unknown in October).
Why are these results useful news for American Capital? Two reasons. First, American Capital collects a management fee from both American Capital Agency and from American Capital Mortgage Investment. Since the fee is in both instances based on the net value of the managed assets, American Capital Agency's last-quarter issuance of $1.1 Billion in new shares (issued at prices above NAV, so old shareholders' equity was increased rather than being diluted at the deal's close) had a direct impact on the monthly fee American Capital has thereafter collected. The year-end share count of American Capital Agency and its NAV suggest net assets over $6.2 billion, for an annual management fee in the range of $77.5 million. Although American Capital had 334.8 million shares outstanding at the end of 3Q2011, it purchased 8.4 million shares during 4Q2011 at $6.97 per share, reducing its share count to about 326.4 million. This means that Americana Capital Agency provides American Capital a management fee of - try the math yourself - about 23.7¢ per American Capital share (about 6¢ per quarter). The more American Capital grows NAV at American Capital Agency, the more this fee income increases. So that 81¢ per share asset growth at American Capital Agency over the last quarter is good news for American Capital longs.
Despite articles that suggest American Capital's repurchases are of no benefit to shareholders (like "2 Stocks That Are Wasting Your Money" by Rich Smith), management at American Capital Ltd. has an apparently outstanding grasp of how to manage your money in a tax-efficient manner. First, American Capital's share repurchases at prices below its net asset value per share add to the NAV of all the prior shareholders. American Capital could not provide as much shareholder value by declaring a dividend because (1) the dividend would be taxable on receipt, whereas NAV appreciation is not a taxable event and thus can be reinvested without tax consequences, and (2) the dividend would only be the millions American Capital distributed, and would fail to capture the difference between NAV and share price American Capital brings shareholders when it buys shares from impatient strangers. Thus, American Capital's share buybacks not only give shareholders more economic benefit immediately, they improve post-tax economic benefit because the reinvested gain goes untaxed until disposition. The genius of this scheme appears utterly lost on Mr. Smith, whose depth of analysis is illustrated here:
This company really can't afford to pay dividends right now. But this begs the question of why AmCap thinks it can afford spending nearly $60 million buying back its dead-in-the-water shares, and whether that's even a good idea.
Rich Smith of The Motley Fool
By contrast, consider American Capital's depth of analysis. Observe its managed fund American Capital Agency (the performance of which is described here). Every REIT must distribute at least 90% of its taxable income (not SEC-reportable "earnings") in order to avoid paying taxes at the corporate level. Compliance means that shareholders avoid double-taxation: they pay taxes based on the earnings or capital gains the REIT would have paid if it paid taxes, but the government doesn't tax these dividend funds twice as they do with ordinary corporations such as Microsoft (at the 35% corporate rate Microsoft pays on taxable income before the dividend is paid, then again in the hands of shareholders who receive the dividends). Nice, right?
American Capital goes a step beyond. Since American Capital Agency's dividend-paying requirement is based on the company's aggregate taxable income rather than on per-share metrics, issuance of new equity above NAV doesn't just increase existing shareholders' NAV, it also reduces the per-share dividend they are required to be issued - and taxed on - in the current year. By allowing American Capital Agency's mandatory dividend for a year to be spread across more shares following issuance without lowering shareholders' NAV, American Capital's issuance of American Capital Agency shares enables all American Capital Agency shareholders to enjoy more tax-deferred reinvestment than could exist under a static share count. For American Capital shareholders, this also has the salutory effect of increasing the retention of funds under American Capital's management at American Capital Agency: the more reinvestment, the more fee income. The beauty of this tax-deferred reinvestment strategy is a blissful sight in these sad times of thick financial analysis.
To better enjoy the benefit of this earnings engine, ACAS launched American Capital Mortgage Investment in August at $20, invested $40m of its own capital in a private offering simultaneous with the IPO, and has held 2,000,100 shares of American Capital Mortgage Investment following the launch. These ~2m shares of American Capital Mortgage Investment have just paid American Capital a dividend of $1.6m, which amounts to about half a penny per share of American Capital. This is a quarterly dividend, mind you, and it is likely to increase as described here. Moreover, American Capital (under FAS 157) is required to report as "earnings" increases in the value of its assets held for investment. This means that as American Capital Mortgage Investment reinvests an additional 25¢ per share it doesn't pay as dividends, American Capital (as a shareholder) gets a tax-deferred "earnings" benefit that increases the fund from which its dividend receipts are being generated, while also increasing the fund from which American Capital (as the fund's manager) earns a management fee. Based on American Capital Mortgage Investment's share count just north of 10m shares and its newly-announced year-end NAV of $20.87 per share (up 91¢ from the prior quarter), American Capital is generating a management fee based on about $208.8m, and thus receiving a bit over $3.1m in annualized fees. This is nearly a penny per share of American Capital - half the annual benefit from the dividend received from American Capital Agency. Because American Capital Mortgage Investment is new and hasn't yet shown the consistent track record of trading above NAV, it hasn't yet put American Capital in a position to issue American Capital Mortgage Investment shares at prices accretive to NAV. As a major shareholder in American Capital Mortgage Investment, American Capital has no desire to issue American Capital Mortgage Investment shares on terms that don't protect its interest as a shareholder. However, if the recent premiumm to NAV follows American Capital Agency's trend and becomes a regular fixture of American Capital Mortgage Investment sahres, American Capital will be able to grow NAV and grow fees by growing invested funds through issuance that also improves American Capital's value as a shareholder. Hard to beat. And so far, ACAS' performance at American Capital Mortgage Investment suggests that American Capital Mortgage Investment is being run from the same playbook as American Capital Agency, giving this scenario real plausibility.
And from the above analysis, it's clear that American Capital's profit motive should continue to drive it to reinvest as much of the earnings at American Capital Agency and American Capital Mortgage Investment as can be supported by their REIT status. The recent decrease in American Capital Agency's dividend to $1.25 per share per quarter (for about a 16% return ignoring capital increases) is calculated to do just that: reinvest more, faster.
And this reinvestment thesis is exactly what Mr. Smith missed when he wrote about American Capital Ltd. and its management's strategy for producing outstanding after-tax returns. American Capital Ltd. has a loss-carryforward from the era of the crash, and if the company were to continue to operate as a BDC while that loss-carryforward remained on the books, it would lose the operating loss portion of the otherwise-valuable tax asset. By deliberately failing a RIC test, ACAS both avoided the obligation to pay dividends and conserved the loss-carryforward to use to offset future earnings. The effect of this is that less of American Capital's future profit will be taxed (either in the hands of American Capital or those of its shareholders; tax efficiency must look at every level of possible taxation). Once the loss-carryforward is consumed, American Capital will be free to reconsider how to conduct operations in favor of maximizing after-tax returns. After all, the only reason to organize as a BDC is to avoid double-taxation - and the only reason to pay BDC-style dividends is to maintain qualification as a BDC. Paying dividends not required to maintain a favorable tax status is simply exposing more shareholder value to faster taxation - a senseless gesture I hope management continues to avoid as long as possible.
Managing Its Own Shareholders' Money
Back in the dark days of early 2009, American Capital's management - though barred from share repurchase by its overhanging dividend obligation and by its precarious situation in default debt covenants, not from nonpayment of debts but for unexpectedly inadequate post-crash tangible net assets - showed that it could still find outstanding investments. American Capital capitalized on the panic's impact on the value of its public debt to repurchase below face value obligations payable to creditors. In one swoop, American Capital improved shareholders' NAV (eliminating debt at face value by spending only a fraction of the face value) while lowering its leverage as it plowed into lengthy negotiations with creditors. A beautiful risk-free investment of capital.
American Capital renegotiated its debt so as to eliminate the pre-crash tangible net asset covenants, and thereby cease paying default-rate interest (a painful insult for someone actually making timely debt payments). After a period of reducing debt in order to avoid pressure caused by repayment deadlines, American Capital has begun making new investment once again. American Capital invested $50 million in mezzanine financing to support the merger that resulted in Survey Sampling International, $15 million in support of Teachers' Private Capital's purchase of Flexera Software, and $10 million in loans to support Rennaisance Learning's K-12 school offerings. These new investments are debt investments expected to pay a specific, calculable return.
Management also invested $40 million in its new publicly-traded managed fund American Capital Mortgage Investment, and pursuant to a new repurchase policy, spent over $133 million (in 3Q2011 and in 4Q2011) buying 17.5 million of American Capital's shares at below-NAV prices ($8.21 per share during a quarter that ended with a NAV of $11.92, and $6.97 in the quarter after that). These are essentially infrastructure investments: American Capital's management is spending funds to enable American Capital to make more money per share for American Capital shareholders, both from new business and from value concentration of all its businesses into fewer shares.
While this new investment is going on, American Capital has continued to deploy its operations personnel to refactor and streamline and improve processes and performance at its portfolio companies. American Capital worked to improve the collectability of its debt investments and increase portfolio companies' operating profits that flow to its own bottom line (as owner of 80% or more of the portfolio companies, it is entitled to file a consolidated return and to include subsidiary earnings on its own balance sheet). Among the things to look for in American Capital's Valentines Day announcement will be the Net Operating Income that American Capital earns after its recent exits from portfolio companies that will no longer contribute to its NOI: that money doesn't come from nowhere, and it's good to see management replacing it effectively.
American Capital Ltd. isn't valued only on the basis of operating income, however. Interest received from its portfolio companies and management fees received from funds under management are both nice, of course, and offer potentially steadier income than from buying and selling whole investments. However, the point of a BCD that invests in big equity stakes is not just debt income but explosive capital appreciation. Even while American Capital slowed in making new investments, American Capital continued to operate a successful pipeline of investment exits. For example, when American Capital exited its portfolio company Value Plastics last September, it did so at a price that was 31% higher than the "fair value" assigned to Value Plastics at the end of the previous quarter. Although American Capital's Sixnet investments were valued at $39.5 million at the end of 2Q2011, it was able to exit those investments during 3Q2011 on terms that saw American Capital receive about $44 million. A similar story existed in the triVIN exit. So, investors care about the quality and availability of deals - especially the prospects for exit from existing investments.
The above-list sales prices do not mean that ACAS' entire portfolio is dramatically undervalued: much of its portfolio seems to have extremely accurate valuation, resulting in closings within 3% of the valuation given at the end of the previous quarter (3Q2011 presentation slides report exits within 1% of last-published investment values over the life of American Capital as a public company; many exists simply do not appear in press releases). Despite this closenes between reported values and sales prices, the variance between defensible FAS-156-compliant "fair value" and actual exit prices (and the need for conservatism where doubt esists) raises the real elephant in the room: where do these valuations come from?
Since American Capital doesn't liquidate its portfolio every quarter, the value of its equity (and its non-equity holdings, for that matter) must for every asset not actually liquidated in a quarter be based on some data other than an actual sales price. Under FAS 157, American Capital must not only report the market value of every asset held for investment but report changes in these values as part of its "earnings". Thus, American Capital must value every investment asset every quarter, which it does with the assistance of outside specialists. And these values impact not only NAV, but "earnings" (as opposed to the taxable income that drives dividends at REITs and BDCs that don't deliberately throw a RIC test to maintain a loss carryforward).
So, where do those values come from?
Everybody Else's Money
The values of illiquid portfolio companies are as theoretically unique and unknowable as the values of specific parcels of real estate - and are valued in essentially the same way. Investments are certainly subjected to valuation using financial modeling, but at the root of much of that modeling the primary ingredient comes down to a word: comparables.
The basis for "fair value" in investments with no ready market depends - as with real estate - on an analysis of comparable sales. And one very good place to get comparable sales data is in a public market for a company that is a "comparable". Thus, the investments of everybody else's money in the public markets have a direct impact on American Capital's NAV.
If corporate debt is broadly in disfavor and nobody wants to buy debt without a government guaranty (for example, during the liquidity crisis at the end of 2008), the debt of an illiquid portfolio company must be marked down at least as much as publicly-traded debt of "comparable" companies - perhaps more so, given the illiquidity discount the market would assign to securities that cannot be freely traded on a public exchange and for which no ready market exists and for which transaction costs are many orders of magnitude higher. The same is true of equity. Illiquid preferred shares, common shares of a company whose name no-one has heard - all these take a beating as the markets suffer multiples compression during a downturn. During the Q32011 conference call, management explained:
This third quarter, I have to tell you, was a frustrating quarter for us, because we experienced very consistent net operating income, consistent with our last quarter. But as you'll see, we of course had depreciation which was driven predominantly by multiples and spreads in the industry as opposed to performance of our portfolio of companies.
Malon Wilkus, CEO (3Q2011 Earnings Call Transcript)
Of course, this means that the reverse is true. A steadily-paying debtor whose bonds are in good standing are worth much more when the bond market is flush with investment. When stock indexes rise, the tide lifts all boats: the indexes are full of comparables whose prices impact the portfolio companies on the books at American Capital. When confidence in corporate credit improves, bonds held as investments look more valuable whether they are on the books of American Capital or not.
As comparables rise or fall, so too rise and fall American Capital's broad portfolio of illiquid midmarket companies and their debt. Thus, after so many post-crash quarters of increasing NAV, American Capital took a NAV loss in 3Q2011 after the worldwide markets were slammed in August. Knowing how the markets have done in 4Q2011, we can discern the tenor of ACAS' NAV change in that quarter. More, even: once the 4Q2011 NAV number is published, knowledge of the run-up the US markets have enjoyed in the beginning of 2012 will provide confidence that the current NAV is actually higher.
The breadth of American Capital's portfolio is one of the reasons it's so desirable: American Capital is, in one sense, a one-stock diversification scheme. (Of course, it also concentrates risk with one management team. This wasn't a bad strategy when Apple looked attractive following Apple's NeXT acquisition, but through some eyes Dell (DELL) looked attractive in 1998, too; one might not invest more than one can risk with one fund manager. On the other hand, a fund manager with the sophistication and performance American Capital demonstrates with American Capital Agency and American Capital Mortgage Investment might not be a bad place to place some confidence.)
It's The Portfolio, Silly
American Capital Ltd. has repeatedly described itself (to the point it's been described as a "mantra") as a "long-term" and "patient" investor. The company is confronted with numerous deal pitches, and management generally passes them by: they're just not attractive enough to invest your money. Better opportunity will come. American Capital may hold nine figures in cash, but management doesn't let it burn a hole in its pocket.
The genius of investing in illiquid midcap portfolio companies is that they are generally too big for founders to sell to other individuals, which creates an exit problem when some factor - estate planning by a major shareholder with numerous heirs uninterested in the business, desire to expand, employee takeover of management from founders - creates selling pressure. The companies aren't public, so they can't dump shares on the open market (there isn't one). The companies aren't small enough to find a buyer by advertising in the paper or a trade journal. Someone big enough to buy them needs to be found. And guess what? It's a buyer's market. American Capital Ltd. can sit back, watching deals pass, until it finds the gem that persuades its deal screeners that the business is right, the earnings are right, the management team is right, and the price is right even if market multiples contract by the time American Capital wants to sell its own stake. The very illiquidity of American Capital's investment targets creates an opportunity to buy businesses on terms not available in the more liquid markets of publicly-traded companies. And a quick look at American Capital's quarterly filings shows that in a typical buyout, American Capital holds not just an equity stake but a debt interest that ensures it is high enough in the investor stack to get paid properly on exit. Unlike a bank - whose interest in deals is limited to the face value of bank-rate loans - American Capital has the freedom to structure deals with convertible high-interest bonds, preferred shares, equity, subordinate debt ... whatever seems like it will make the most sense to make the deal happen, to keep American Capital in control, and to get American Capital paid.
It's much more diverse than many individuals are likely to assemble on their own, and seemingly designed to avoid sector-specific risks by avoiding sector concentration. Internet marketing, medical devices, funds management (yes, American Capital's management of American Capital Agency and American Capital Mortgage are provided through a fully-owned subsidiary that has a "fair value"), transmission repair, vehicle fleet supplies, exhibition space operation ... the list is enlightening: did you know people could make money in all these things? Some investments seem peculiarly suited to an economic downturn, or like the dental practice management business acquired in 2008 are calculated to be acyclical.
The diversity of this portfolio means that it is not really the product of one business, but is so diverse that it is arguably a proxy for the larger market. The difference is that American Capital bought it under conditions that convinced it it could exit profitably even under a scenario of a multiples contraction, and since American Capital is trading below NAV, they are all on sale to the extent of the NAV discount. Over the last year, this discount has frequently been on the order of 40%. Some investments, like the American Capital subsidiary European Capital, offer an opportunity for a double discount: American Capital trades at a discount to NAV, yes, but its portfolio company European Capital - which is itself a basket of portfolio companies - is assigned a FAS-157-compliant "fair value" that is a discount to its NAV. So, portfolio companies that are part of European Capital are on sale twice.
While the duration of American Capital's discount to NAV is (as the double-discount of holdings held by European Capital) a matter of speculation - likely until after the resumption of the dividend once the loss carry-forward is consumed and tax efficiency begins to create value in resumption of tax-pass-through status - the fact that American Capital's share price will reflect changes in a broad market of comparables (even if at a discount) means that a bullish outlook on the broad market favors a bullish view on American Capital as a (0.4:1 leveraged) proxy for the broader market. Since we know the market has been heading up since the last publication of an American Capital NAV value (as have American Capital prices, without other news), we can expect certain associated favorable things in the upcoming earnings announcement. Earnings and NAV, for example, will be up. Optimism in the long-term direction of the markets would, if American Capital is a rough proxy for broader markets, favor optimism in the long-term direction of American Capital.
As improvements in employment, consumer confidence, discretionary spending, and other metrics of the broad economy continue to look less bleak as the crash heads further into the rear view mirror, American Capital's businesses will move with the broader market back into higher valuations - not just because optimism expands comparables' multiples (which does happen), but also because American Capital's businesses enjoy the benefit of the same macro trends.
Investors whose marginal ta rate is less than the 35% corporate tax rate will benefit from American Capital's historic status as a BDC (which, like REITS, avoid taxation by making minimum required distributions to shareholders who pay taxes without double-taxation) will do better holding a portfolio of investments through American Capital than through a holding company that pays taxes at the corporate level. This effect is magnified for investors holding shares in a tax-deferred account. Consider an investment in Warren Buffett's well-respected Berkshire Hathaway (BRK.B), owner of such diverse businesses as Dairy Queen (itself the owner of the delicious Orange Julius), GEICO Insurance, the Burlington Northern railroad, an Israeli tool company, and Star Furniture. Historic book value per share increases have been 20% per share after Berkshire's payment of profits at the corporate tax rate. (Note: Warren Buffet doesn't use leverage because he doesn't think a careful buyer needs it. American Capital has reduced its post-crash leverage to 0.4:1. The risks of Berkshire Hathaway and American Capital aren't the same risks. This is a discussion about tax efficiency, not portfolio similarity.) Since Berkshire Hathaway pays no dividend, there's no reason to hold it in a tax-deferred account (unless one plans trading it, ick). But what if one could get the reinvestment of proceeds of carefully-selected portfolio companies without the impact of a 35% annual tax on the income of the portfolio? Some of American Capital's strategies appear to offer some limited internal deferral on reinvestment, even outside tax-favored accounts.
There's a lot to love in American Capital: quick diversification into a leveraged portfolio reflecting a broad cross-section of industries without the risks of leveraging one's own portfolio directly, the tax efficiency of avoiding double-taxation, the ability to enjoy American Capital's near-term earnings tax-free due to crash-era loss carry-forwards, management with a financial expertise that's been demonstrated nicely in its performance with American Capital Agency and American Capital Mortgage investment, steady and growing funds-management income from developing businesses like American Capital's management of AGNC and MTGE, investment at a discount to NAV (including in holdings like American Capital Mortgage Investment, which outside of American Capital's portfolio must be purchased at a NAV premium rather than at American Capital's huge NAV discount), and double-discounting of investment price in holdings like those in European Capital. Then, there's the fat deal stream from which American Capital is permitted to cherry-pick investments, and investors' ability to participate - even with small sums - in a private equity business involving illiquid portfolio companies American Capital can bargain for at attractive prices because bidders are so scarce in the privately-held mid-market company marketplace. On Valentine's Day, I'll look for signs of management's love in steady net operating income and growing net asset value. And I'll stay true to the managers who keep sending me their love, quarter after quarter.
And if you don't love American Capital, at least buy your Valentine a box of those little message-bearing heart-shaped candies. The New England Confectionary Company, the manufacturer of those sweet little love-note hearts, is an American Capital portfolio company.