Last week, European Capital's management published a statement regarding its performance over the second half of 2011. This article discusses the meaning of these results to investors of its manager, American Capital Ltd. (ACAS).
Once a publicly-traded fund like American Capital Agency (AGNC) or American Capital Mortgage Investment (MTGE), European Capital was taken private by American Captial Ltd. in the first quarter of 2009 in an all-stock transaction. American Capital's acquisition illustrates an extremely rare instance in which issuing shares at a price below net asset alue per share still had an accretive impact on incumbent shareholders of the issuing company. Usually, to achieve accretion requires share issuance at a price above NAV. In this case shareholders of American Capital benefitted because European Capital's shares were bought at an even greater discount to its NAV.
At the time of the transaction investors had the impression that acquiring European Capital would allow American Capital to recognize as an asset the value of European Capital's portfolio, which was worth more than European Capital itself. But that would assume our mandatory accounting principles followed a rule of reason instead of the rules as written ....
Since European Capital's portfolio companies are not directly held by American Capital, it does not list those portfolio companies among its holdings: it only lists European Capital. Because European Capital's nearest comparable publicly-traded investment (American Capital itself) trades at a substantial discount to NAV, the "fair value" assigned by American Capital to its European Capital holdings in compliance with FAS 157 is subject to a similar discount. Thus, the FAS-157-compliant "fair value" of American Capital's holdings in European Capital Ltd. at the close of 2011 was $620.7 million, including all of European Capital's outstanding equity which had a fair value of $547 million. (The other $73.4 million consists of currently-performing debt holdings bearing a cupon of $7.8%) The $547 million equity valuation is considered "fair value" under FAS 157 despite that European Capital's holdings at that point had a "fair value" of $814 million. American Capital's equity interest in European Capital is therefore being subjected to a NAV discount exceeding 30% for no other reason than that American Capital maintains a corporate shell between it and European Capital's component investments. (Between the beginning and the end of 4Q2011, that NAV discount actually grew from about 31% to nearly 33%.)
The discount of $267 million from the value of European Capital's holdings isn't lost to a taxing authority or in a bad business deal: it's still deployed by American Capital (which manages European Capital) to make money for its shareholders. It's non-reflection on American Capital's books is an accounting fiction born of FAS 157. It can be created and destroyed by the decision of American Capital to create or dissolve interposing entities. It has no effect on the money American Capital can earn for shareholders.
The missing $267 million - amounting to a hair over 81¢ per outstanding share of American Capital - isn't missing at all at the end of 2011, except in American Capital's reported assets per share of $13.87.
What's It Worth?
At the close of 2011, European Capital was one of 152 American Capital portfolio companies. European Capital itself had 91 portfolio companies. Although European Capital enjoyed €53 million in net operating income over 2011 (up 11% from 2010), the value of the portfolio reflected the volatility affecting the European markets generally: portfolio appreciation of €98 million in the first half of the year was followed by a diasterous second half that left the portfolio down a net €102 million for the year. Balance-sheet-strengthening exercises (e.g., deploying liquidity on realizations to accomplish debt repayment to control the debt:equity ratio) included not only refinancing debt with newly-raised AAA-rated external (i.e., not from American Capital) debt, but exits of portfolio investments that included net realized losses of €29 million. Over 2011, European Capital experienced a €2 million decrease in NAV (from €629 million to €627 million) to achieve a stock-price-only return of -0.003%, which was almost exactly the return of the S&P 500. However, exchanges containing European companies such as those owned by European Capital were down: the FTSE fell about 8% for the year, and the DAX over 15%. American Capital achieved this index-beating result at European Capital while lowering the company's debt:equity ratio to 0.7:1 from 0.8:1.
The fact that American Capital is able to perform minor miracles of European investment capital preservation in the face of the European financial turmoil suggests that it's able to rather better than indexes in Europe. This index-beating performance is the sort of evidence Warren Buffett suggests investors think about in determining whether they prefer management to keep funds for investment, or prefer a dividend (see p.99-100 of Berkshire Hathaway's (BRK.B) 2011 Annual Report). American Capital's performance suggests that it is a competent steward of investors' funds: beating comparable performances by 8-15% in a year is pretty good. Investments in its hands seem worth more than in an average comparable investment.
For comparison, American Capital's overall NAV was up 30% in 2011, while the S&P 500 was virtually flat. Berkshire Hathaway, which also makes most of its return from the performance of portfolio companies, increased Class A (BRK.A) shareholder's equity from $95,453 per share to $99,860 per share over the same period, for an S&P-500-beating increase of 4.6% - though this increase in book value understates the increase in intrinsic value as it neglects substantial assets involving the time-value of money held and owed. There's little question that American Capital has been making good use of investors' funds since the economic recovery began, and little room for complaint.
Based on the conclusive thrashing of the comparative FTSE and DAX indexes, European Capital is being managed more than competently by American Capital. (For those wondering if 2011 was anomalous, the 2010 NAV increase at European Capital was 19% over the prior year and at American Capital the same-period performance was a 29% NAV increase.) The European Capital performance also suggests effective underwriting discipline at American Capital, as both European Capital and American Capital have increased NAV at rates that outperform the markets in which their investments are located.
Since American Capital has its entire NAV to deploy for investment, and the entire NAV of European Capital to deploy for as well, shareholders' ability to buy the whole basket of 242 portfolio companies at a 30%+ discount is a bargain. More than that, though, shareholders get the 91 European Capital portfolio companies at a double discount: American Capital trades at a NAV discount exceeding 30%, but its NAV includes another 30%+ discount for the entire basket of European Capital portfolio companies. In effect, the double-discount understates American Capital's NAV by a hair over 81¢ per outstanding share of American Capital. Adding this to American Capital's last-reported NAV of $13.87 yields an investable net capital at the close of 2011 of $14.68. Ignoring that the markets have increased since New Years (that is, all the comparable assets against which American Capital's assets are assigned a "fair value" have gone up, raising with them the fair value of American Capital's portfolio), the share price of $8.94 represents a discount of approximately $5.74, or about 40%, from the value of American Capital's invested net assets per share. Since the market condition improvements and equity index increases since the beginning of January have worked to improve the conditions in which American Capital's and European Capital's portfolio companies operate and to increase their value along with the comparables in the relevant indexes, the 40% discount described above - which is based on year-end portfolio values - understates the discount at which investors presently participate in the portfolio of investments amassed by American Capital and its subsidiaries.
It also suggests that the share buyback program instituted last year will have a tremendous magnifying effect on shareholder value, as each dollar of outstanding shares retired by repurchase concentrate into the remaining shares at least $1.67 in investible portfolio assets. The portfolio includes the double-discounted European index-beating European Capital Ltd., an interest in the double-digit-dividend champion American Capital Mortgage Investment, and the manager that controls (for a fee) both those companies and American Capital Agency. Under these conditions, the principles outlined in p.99-100 of Berkshire Hathaway's 2011 Annual Report clearly militate against dividends and toward placing investible funds in the hands of American Capital's capable management.