A news item recently reported as "news" that American Capital Mortgage Investment Corp. (MTGE) would double its share count in a secondary offering organized by its external manager, American Capital Ltd. (ACAS). The story reported that shares fell 1.5% in the after-hours period in which the announcement was made. This price action is enough to make one wonder who owns these shares, and how they can so misunderstand their investment.
The fact that American Capital Mortgage Investment's next round of fundraising would have a huge fractional impact on the firm was presented here last month as a way American Capital Ltd. would grow the value of its holdings in American Captial Mortgage Investment. As American Capital Mortgage Investment's largest incumbent shareholder, American Capital Ltd. has little incentive at all to dilute its equity by giving it away to low-bidding strangers. Yet, American Capital Ltd. will issue shares of its managed fund - it just won't dilute anyone's equity interest when it does.
What Is Dilution?
Let's consider a company we know pretty well: Apple Inc (AAPL). Apple sells electronic devices and software as fast as can be, has plenty of cash to execute its business strategy, and would enjoy no meaningful performance improvement with the addition of a few billion extra cash. Apple doesn't need to issue new shares. As an exercise, though, let's imagine what would happen if Apple were to issue shares under these circumstances. Everyone who bought Apple thinking that its stock was underpriced based on its per-share metrics (e.g., earnings per share, earnings growth per share, etc.) would have to refigure their math on a new share count.
Since a little extra cash won't improve the company's performance in the markets in which it makes its living, the effect of new shares is to increase the denominator without having much impact on the numerator. The effect would be that shareholders' holdings are backed by less of the good business in which they invested than they enjoyed just before the new issuance. That's dilution.
Isn't Issuing New Shares Always Dilutive?
Imagine you held shares in a company whose assets were all highly liquid treasury instruments with an easily knowable value of exactly $10 million, more of which such assets would be readily available on the open market if additional capital were available. Imagine this company had enough government-backed notes that each share had exactly $10.00 in equity behind it. (You may have worked out that this company has one million shares outstanding.) Now imagine the company doubles its share count by issuing another million shares to strangers willing to pay $11 for each share. After the transaction, a share won't be a 1/1,000,000 slice of a $10m investment portfolio, it'll be a 1/2,000,000 slice of a $21m portfolio. Each share moves from having assets of $10.00 behind it to being backed by assets of $10.50 apiece. The company doubles its share count, but adds more money per share than held by the company for prior shareholders. This increases the assets backing each share.
If the company is investing in something that's not in scarce supply, and can be expanded by the simply expedient of adding capital, these shareholders fare very differently than those of a tech firm that prints shares. Instead of having their interest in the firm's returns decrease with issuance, they enjoy an increase in the capital invested for each share - and they enjoy the firm's resulting ability to make that much more money per share. In the example here, the firm doubles its share count but more than doubles its capital, and presumably more than doubles the earnings of the enterprise. The per-share metrics improve.
Instead of diluting value, a transaction like this accretes value.
Accretive Issuance: Fact Or Fiction?
American Capital Ltd. is (through a subsidiary) the manager of not only American Capital Mortgage Investment , but also American Capital Agency (AGNC). A look at American Capital Agency shows that it launched in 2008, just in time to be hit by the financial crisis. Nevertheless, it has improved NAV from less than $20 (following a $20 IPO from which expenses had to be paid) to nearly $28 per share at the end of 2011. This NAV improvement has more than one source, but among them is the fact that American Capital Agency has traded above its NAV for much of its existence, during which time it has issued shares above NAV on numerous occasions. Most of the equity now in American Capital Agency was raised in the last few years, at prices well north of the $20 IPO and even north of the NAV on the date of issuance. In the October 2009 issuance - the second made since the IPO - NAV accretion as a consequence of that sale amounted to 63¢ per share. This was accomplished by selling, at $26.60 per share, shares that at the end of the issuing quarter had a NAV of $22.48 per share. That this was a great deal for incumbent shareholders - and the buyers at $26.60 - is reflected in American Capital's performance as it managed American Capital Agency from 3Q2009 through the present:
(Click to enlarge)
The blue line reflecting share price (up about 7.8% over the period) does not include the amounts distributed with each of the little blue arrows, which reflect the double-digit dividend American Capital Agency has steadily paid since it first operated. The total return calculation requires the addition of $13.85 to the share price reflected in the blue line. But the share price is really more of a popularity contest than a measure of the company's NAV. Much less volatile than share price, NAV at an mREIT like American Capital Agency or American Capital Mortgage Investment is the principal with which the manager earns each fund's returns. As that principal grows, so grows the safety of the fund's return. And as at American Capital Agency, assets per share have been growing at American Capital Mortgage Investment.
American Capital Mortgage Investment's Upcoming Offering
American Capital Mortgage Investment has registered some 11.5 million shares for public offering, which is more than the fund's entire count of shares currently outstanding. An above-NAV issuance of such relative size will have an immediate and positive impact on American Capital Mortgage Investment's NAV - and on the value of Americal Capital Ltd.'s stake in the company. The publicly-traded funds managed by American Capital Ltd. have been protected from the dilutive issuance and overpriced expenses that threaten certain other funds (as illustrated by Apollo (AINV) in a multipart article here and here); moreover, American Capital Ltd. has been rebuilding its image after the crash and threatened bankruptcy reorganization that weighed on it through 2008 and 2009. To issue shares of a managed fund below NAV would work against the strong story American Capital's management has been telling with its performance internally and within its publicly traded managed funds.
Rather than sell the offering, shareholders would benefit to acquire shares instead - history (and math) is on their side.