American Capital Ltd. (NASDAQ:ACAS) is a business development company ("BDC") that invests not only in the debt issues that make most BDCs regular dividend payers, but in whole companies. This year, under pressure from activist investors, management announced it's looking for a buyer rather than spinning off the several dividend-paying BDCs it planned to launch last year. The potential for near-term purchase puts the company's diluted per-share value into sharp focus.
Factors Impacting Value at ACAS
Net asset value ("NAV") per share is calculated not only from the company's book value -- the FAS-157-compliant "fair value" of investments, less debt, plus cash -- but also from its share count. Since options should be assumed to be exercised to provide the most conservative estimate of NAV per share, it's necessary to consider both outstanding shares and shares represented by outstanding options. ACAS' regular reports of NAV are all calculated based on the company's outstanding shares; it does not report NAV on a fully-diluted basis. When asked, ACAS' representative said this was because "we don't have to." This article presents fully-diluted NAV calculations based on options last known outstanding at year-end 2015.
Over the quarter, book value changes as the metrics that drive "fair value" estimates change. These can work in either direction, depending on the performance of ACAS' portfolio companies and the macro factors that change how comparable companies (to the constituents of ACAS' portfolio, not to ACAS itself) are valued in the market. Very little estimation can be done on this, as ACAS shares little information about the calculation of "fair value" at its individual holdings. Actual exits can provide information, but most of the portfolio will not be subject to a transaction in a given quarter.
Since ACAS is repurchasing shares at a discount to NAV, ACAS is spending cash (decreasing its book value) while reducing its share count -- and, if ACAS doesn't issue new options, also its diluted share count. Both changes to the value of ACAS' assets and changes to its fully-diluted share count can materially affect ACAS' fully-diluted NAV per share.
Value of the Assets
ACAS' portfolio is predominantly an illiquid collection of diverse portfolio companies.
Since ACAS' assets' valuation is driven by the valuation of publicly-traded comparables, changes in the overall market impact its valuation. Although 1Q2016 was volatile, the broad markets moved up a few percentage points over the quarter:
If new changes in macro factors had developed over the quarter, these would have been reflected in the broader markets. Shareholders haven't been adversely affected by that kind of valuation impact. The remaining question is whether ACAS' specific holdings have had some kind of experience that would impact their fair value. The only relevant press release since the end of 2015 addressed ACAS' sale of commercial mortgage-backed securities ("CMBS"). Management reported the CMBS portfolio had a FAS-157-compliant "fair value" of $40.4 million, but that ACAS received net cash of $64.9 million in the exit. It's unreasonable to expect that management can sell all or most of ACAS' assets for more than 160% of their last-published "fair value." Assuming that management issued no new options in the quarter, and reducing the diluted share count by management's announced repurchases over the quarter, the $24.5 million increase in book value from the CMBS exit alone (exchanging an illiquid, value-estimated asset for cash that had a "fair value" equal to its face value in cash) had the effect of increasing NAV by nearly 10¢ per diluted share.
Retirement of Shares
On December 31, 2015, ACAS' fully-diluted net asset value per share ("NAV") was $18.68. At that time, the outstanding share count was 242.8 million and the overhanging options amounted to an additional 32.2 million shares with an average strike price of $9.66. If management issued no new options over the quarter, ACAS' repurchase of 21.2 million shares during 1Q2016 reduced its fully-diluted share count from 274.8 million to 253.6 million -- a 7.715% reduction in outstanding share count.
If ACAS had repurchased these shares at market prices equal to its fully-diluted NAV, the reduction in diluted shares would have had no effect on ACAS' fully-diluted NAV. Management did not repurchase the shares at a price near ACAS' fully-diluted 4Q2015 NAV of $18.68, but at an average price under $14. By repurchasing shares with a fully-diluted NAV just over $396 million (at $18.68 per share) while reducing cash by a purchase price just under $296 million (at $13.96 per share), ACAS lowered its NAV per share denominator faster than its numerator, thereby raising NAV per share by about 34.5¢/share even if ACAS had no other change in asset value over the quarter. What is more, management accomplished this feat without incurring a taxable transaction: the entire increase in NAV is an after-tax increase. While this means the transaction will not appear in metrics like earnings or net operating income, it is a real change in the net assets per share and should be expected to impact the price at which ACAS is sold, in whole or part, in connection with its announced solicitation for offers to buy the company or its business lines.
Diluted share count was not the only thing to change at ACAS over the quarter, however. The fair value of ACAS' assets whose value must be estimated varies with the price of comparables, and the broad market (as measured by the S&P 500 performance from the beginning of the year) was up more than 2%. We know that ACAS' CMBS portfolio, whose asset value was estimated, was liquidated for a "fair value" increase of $24.5 million. Adjusting ACAS' portfolio value to reflect this gives a fully-diluted quarter-end NAV per share of $19.17, of which 99.4¢ per share is cash ($507.5 million after adding cash from the CMBS sale, less the share repurchase cost of $296 million, divided by post-quarter fully-diluted share count). If the non-cash portion of ACAS' assets experienced the same ~2% increase in fair value enjoyed by the broader market, the non-cash NAV would be about $18.28 per share, and adding cash back to the NAV would yield a NAV of about $19.27.
Assuming that ACAS' single-largest holding experienced a 2% decline in "fair value" and that the rest of its non-cash net value increased by 2% to reflect the broader market, ACAS would have a non-cash NAV of $18.11 per share (on just under $4.6 billion in non-cash assets) and a NAV with cash of $19.10 per share (on net assets of $4.845 billion).
In 2015, management issued options on 500,000 shares that are included in the above calculations. However, as the share count dwindles due to repurchases while market prices for ACAS shares remain significantly below diluted NAV, there is more and more risk to shareholders from any issuance of options with a strike price near market value. Management provides a little chart in the 10-K illustrating what a disaster below-NAV share issuance is, and options priced near market values have the exact same economic impact on shareholders.
As an illustration: new options on 10 million shares, with an exercise price of $15.50 per share, would raise ACAS' assets by $8 million on exercise while increasing the diluted share count by 500,000. Today, this would reduce the estimated diluted NAV from $19.10 per share to just under $18.97, or nearly 1% of NAV. Since the repurchase has been underway, share count has fallen significantly from the authorized share limit, so considerably more authority exists for options grants than the 10 million shares hypothesized above.
For shareholders to get the full benefit of ACAS' share repurchases and portfolio appreciation, management must keep its hands out of the cookie jar. As a sale-of-business transaction approaches, the risk that exiting executives will vote themselves a final bonus on the backs of shareholders gets worse and worse.
Other risks include the possibility of a catastrophe that impacts asset valuations globally, and consequently the "fair value" of ACAS' entire non-cash portfolio. The liquidity crisis of 2008 is an example of such a shock, but a smaller shock could still have a material impact on ACAS' short-term NAV and, consequently, its prospects for sale at the most favorable price.
ACAS' significant discount to NAV, coupled with its aggressive repurchasing campaign, offers an immediate and material upside to NAV. Since metrics like operating income and earnings do not capture the effect on NAV of repurchase, NAV continues to be the ideal metric for assessing management's success in improving shareholder value at ACAS. Assuming no new options issuance, it is likely that ACAS' net asset value per share at the time of this article is slightly in excess of $19 per share, or approximately 25% above ACAS' share price (at the time of this writing) of $15.25.
Disclosure: I am/we are long ACAS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.