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American Capital (NASDAQ:ACAS)

Q3 2012 Earnings Call

November 01, 2012 2:00 pm ET

Executives

Pete Deoudes - Director of Equity Capital Markets

Malon Wilkus - Founder, Chairman, Chief Executive Officer and Chairman of Executive Committee

John R. Erickson - Chief Financial Officer, Principal Accounting Officer and President of Structured Finance

Analysts

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

John Hecht - Stephens Inc., Research Division

Angelo Guarino

Greg M. Mason - Stifel, Nicolaus & Co., Inc., Research Division

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Operator

Good day, and welcome to the American Capital Shareholders' Call. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Pete Deoudes in Investor Relations. Please go ahead.

Pete Deoudes

Thank you, Sue. Thank you, everyone, for joining American Capital's Third Quarter 2012 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 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 by law.

An archive of this presentation will be available on our website, and the telephone recording can be accessed through November 16 by dialing (877) 344-7529. The replay passcode is 10019010.

To view the Q3 slide presentation that corresponds with this call, please turn to our website at americancapital.com and click on the Q3 2012 Earnings Presentation link in the upper right-hand corner of the homepage. 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; Sam Flax, Executive Vice President and General Counsel; Rich Konzmann, Senior Vice President, Accounting and Reporting; and Tom McHale, Senior Vice President, Finance.

With that, I'll turn the call over to Malon.

Malon Wilkus

Thanks, Pete. I hope everyone on this call, who was in the path of Hurricane Sandy, has managed to get through to this storm safely and in good health. Our hearts go out to those who have suffered. We, at American Capital, were fortunate to have fared well and based on our initial assessment, so have our portfolio companies.

Moving to the business at hand, this was a very straightforward and successful quarter for American Capital. So I won't be reviewing individual slides, but instead I'll give a brief overview of the quarter before I open it up for questions.

You can, of course, reference the slides during the Q&A. The performance of our portfolio companies, the diversity of our business lines, our focus on shareholder returns and the growth of our book value continued to increase shareholder value. In the third quarter, our book value grew by $0.77 to $17.39 per share, driven by net operating income and unrealized appreciation across 4 of our 5 business lines, producing a 19% annualized return for the quarter. This, coupled with our balance sheet management strategies, leaves us well positioned for the remainder of 2012 and into 2013.

American Capital, LLC, our asset management affiliate, at $103 million of fair value, remains our largest portfolio company. Its valuation in the quarter was flat as increased assets under management was offset by a reduction in forecasted growth.

In the third quarter, we closed on our second CLO totaling $362 million, and we raised $1.2 billion in additional capital at our mortgage REITs. We are pleased that we were able to grow our existing funds under management and look forward to increasing the number of funds under management over time.

In fact, we just announced that Mr. Paul Hanrahan has joined American Capital from the AES Corporation, a Fortune 150 global power company, where he served as President and Chief Executive Officer from 2002 to 2011. While he was CEO, AES generated total returns for stockholders over 3x that of the S&P 500. Paul has joined American Capital LLC, our alternative asset management portfolio company, as CEO of newly formed American Capital Infrastructure to manage investments in global energy infrastructure assets, including power generation facilities, power distribution and transmission networks, energy transportation assets and fuel production opportunities.

He is initially joined by Rich Santoroski, Managing Director; and Rajeev Garside, Vice President, both with excellent energy infrastructure experience. Let me also mention that due to securities law considerations, we'll not be able to provide further information regarding capital raising plans or investing in this sector.

Moving on to our operating companies, in the U.S., they have had a slight aggregate revenue increase and a modest adjusted EBITDA increase in the past 3 months year-over-year. Our sponsored finance companies had a moderate aggregate revenue increase and adjusted EBITDA increase in the past 3 months year-over-year. Our structured products investments produced $5 million more in income in the third quarter than in the same quarter last year, totaling today now $19 million. In European Capital portfolio companies had a moderate aggregate revenue increase and a modest adjusted EBITDA decrease in the past 3 months year-over-year.

We were able to drive approximately $20 million of appreciation at each of 3 business lines. Our operating companies, sponsored finance and structured products. Additionally, the value of our equity investment in European Capital increased $77 million as the stock price to net asset value ratio of comparable public funds increased and the euro appreciated in value against the dollar.

Our balance sheet management is also driving shareholder value. During the quarter, we continued to strengthen our balance sheet and lower our cost of capital as we refinanced our secured debt with a $600 million 4-year secured term facility and obtained a new $250 million 4-year secured revolving credit facility.

Relative to the facility it replaced and assuming drawing 75% of the secured revolving credit facility, we lowered our cost of debt to capital by approximately 3.5%.

We also repaid an additional $150 million on our balance sheet -- I should say, on balance sheet securitized debt. Given our structured -- our strong balance sheet and liquidity, we were able to enhance shareholder value with our stock repurchase and dividend program.

With 11.4 million of shares repurchases during the quarter, we have now repurchased 12% of our shares issued prior to the initiation of this program during the third quarter. This has increased book value by $0.90 per share.

We remain committed to our stock repurchase and dividend program and closing the stock price discount to our net asset value per share. As a reminder, under this program, we intend to use our cash flow to pay dividends once our stock price trades at or higher than our book value.

We're also committed to continuing growing our portfolio of companies with added investments in both our sponsored finance and buyout teams are quite active in the market.

Finally, I'd like to point out on Slide 16 that the rate of return of all the investments that have been made by American Capital, $25 billion in total commitments of senior debt, subordinated debt, equity, structured products and fund investments, have totaled 9% IRR as of the end of the third quarter. This is a stark improvement from the same calculation at the end of the second quarter of 2009 low point, when our investment value showed a 3% rate of return and 3 of our static pools were showing negative returns.

Today, only 1 static pool, 2007, has a negative return at 4% -- I should say, negative 4%, and we intend to work hard to turn that pool of investments around, as we have the other 2.

Hopefully, these comments give a high-level snapshot of American Capital's performance in the third quarter. So now, please, let's open up the call to questions

Question-and-Answer Session

Operator

[Operator Instructions] Our first question will come from Rick Shane of JPMorgan.

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

I just want to relate a slide from last quarter to the additional detail you provided this quarter. Last quarter, you guys disclosed $22 million of net nonrecurring income related to moving things on and off of accrual status. This quarter, on Slide 6, you break that out in greater detail, and you basically show last quarter, there was 27 positive, minus 5, net 22. And this quarter, you show $9 million of non-accrual adjustments, so it's either with dividend income, that, I understand. I just want to understand the $10 million negative adjustment related to non-accrual on debt investments? And just to make sure that, that's a nonrecurring item and that we're looking at that in the right way?

Malon Wilkus

Yes, that would be a nonrecurring item. I mean, here you see, every quarter, you have things going off and -- on and off in non-accrual, but we're trying to give you the ones that have cap in that quarter so that will be nonrecurring.

John R. Erickson

And Rick, we fast forwarded to the 10-Q disclosed that we have every quarter to Slide 6. So this is recurring disclosure.

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

And John, just to make sure I understand this, we definitely understand when stuff comes off. Is the line that shows the minus $10 million here basically catch up or previously accrued, and that's why is nonrecurring? Because it actually, based on this data, looks linear and that's what confused me.

John R. Erickson

Yes, it was previously accrued. You're correct.

Operator

The next question comes from John Hecht of Stephens.

John Hecht - Stephens Inc., Research Division

You guys have had a relatively sizable increase in dividend from your equity portfolio for the past few quarters. And I'm just wondering if you could comment how volatile might that might be and what kind of conditions create volatility?

Malon Wilkus

Well, the biggest increase, say over the last year and, certainly, over the last several years, has been the dividends coming off of our investment in American Capital, LLC, our alternative asset management company. That income, we believe, is highly reoccurring and, in fact, we think it has elements of being countercyclical.

John R. Erickson

Yes, and then the other is you got dividends coming through the cycle, we had a number our preferred stock investments that went on nonaccrual. Now with equity values coming back, what you're seeing is those are going, in fact, on accrual and so you're building up the stream of preferred stock that is accruing. So there is an increase their as you can see on the line on that chart on the line 6. So that the preferred stock equity investments are having more of the accrual because they're performing better.

John Hecht - Stephens Inc., Research Division

And so that would just be a credit-dependent situation for the preferred -- stream of preferred dividends, I'd take it?

John R. Erickson

Yes, credit or valuation, I mean, because unfortunately, when multiples decline, even if the company's credit is fine, we're put on nonaccrual, so it's a valuation issue as well.

John Hecht - Stephens Inc., Research Division

Okay. And then as a follow-on to that, you had an increase in the run rate of earnings over the past several quarters and, obviously, the cash flow associated with that. And there are some ownership limits on the repurchase program. So I'm wondering as your cash flows increase, what does it do to your thinking about the repurchase program and/or potential expectations for dividend payment?

Malon Wilkus

Well, as you know, we have extended the -- our board has extended the stock repurchase dividend program through the end of next year. We did the largest amount of stock repurchases last quarter at $125 million. And we remain highly committed to it. We think it's incredible by -- and an outstanding use of our capital. But we don't -- we really don't want to give any further guidance on it than that.

Operator

Our next question is from Angelo Guarino of DTI.

Angelo Guarino

In your presentation regarding your debt refinance, there was a piece of information in that, that this is my first opportunity to ask about. Under -- when you talked about ACE I, you actually detailed there that you had a potential $33 million incentive fee based on the fair value of that time. And the fair value at the time was $590 million. Now we're up to, as I see in the presentation, we're up to almost $620 million. And you also talk about that there's up to a 30% incentive fee. So my question would be, when you disclosed that potential $33 million, were you already at that 30% latter? And can we think about -- if that was, if the answer is yes, can we think about the excess AUM compared to $590 million as being a 30% return? And how do we think about the timing of when that would actually show up on the balance sheet?

Malon Wilkus

Let me just say that, you're right that we have a carried interest opportunity in American Capital Equity I, and we have a similar one at American Capital Equity II, we call them ACE I and ACE II, and the ACE I is in the money, to a degree, it's not at that upper-level, the highest level that we could earn there, but it is in the money. ACE II is not. It hasn't quite hit the hurdle rates that would allow it to be in the money. But also, let me just say that the present value of the carried interest that is in the money is really a fairly insignificant amount relative to the total valuation of American Capital, LLC, our asset manager. And that's by the way, one of the reasons why I said earlier on one of the last questions was that the consistency of the dividend coming off of our management company, we think, is very high in part because there's very little carried interest-driven income coming off of our management company. That may change in the future, but that's the current status.

Angelo Guarino

So when -- and thinking about these potential incentive fees, on the carried interest, when does that get -- for these ACE II, ACE II, when does that end up getting scored? And is there...

Malon Wilkus

It'll be -- you don't actually pull any cash out of -- or as a result of that incentive fee until you get your complete cash-on-cash returns. And I don't frankly know, it will be some years yet before that would occur. And of course, that's still subject to the final ultimate performance. These are -- these funds had lives of 9 or 10 years with extension periods, and we're still a ways before we get toward the end of those lives.

Angelo Guarino

And to follow up on John's comment about the retained earnings and income tests, and change in ownership test. Do you have this -- do you have a by-law set up such that you have good control over inadvertent ownership changes that might affect - you got much more aggressive with your buybacks this last quarter, which was lovely to see. But do you have things in play that will allow you to manage that and to protect against kind of inadvertent third parties changing and messing up the carry-forwards?

Malon Wilkus

Yes, Angelo. If you recall, go back -- if you refer back to the proxy that we had for the annual shareholder meeting this past spring, we did put a 3, 2 limitation restriction in place. So there are some protections now that, if a shareholder did over the 5%, but obviously, we're also managing that test. We're monitoring our cushion under that test and our intention would be not to get so close that some one investor could inadvertently knock us out. So we're monitoring it closely.

Operator

The next question comes from Greg Mason of Stifel, Nicolaus.

Greg M. Mason - Stifel, Nicolaus & Co., Inc., Research Division

You talked about the valuation the asset manager was held flat this quarter because you expect lower growth going forward. Most of that growth has come from agency. Can you talk about why you're changing your expectations for growth at the asset manager?

Malon Wilkus

No, it's -- that really is something that we won't comment on other than the statement we made earlier.

Greg M. Mason - Stifel, Nicolaus & Co., Inc., Research Division

My follow-up question to that, the dividends from the asset manager have been growing about $5 million per quarter over the last several quarters. As we think about that cash flow, I know you said it's definitely very stable. But how should we think about the continued growth in those potential dividends from American Capital, LLC? Could we continue to see them to grow at the pace where they have been the last few quarters? Or would that be an aggressive assumption?

Malon Wilkus

Yes, obviously, we were indicating we've taken the growth assumptions down in the manager. So you would probably infer from that, that the dividend growth would correspond to that change in growth assumptions.

Operator

[Operator Instructions] Our next question comes from Jonathan Bock of Wells Fargo.

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Malon, with $300 million cash on the balance sheet and now of course, the $250 million in undrawn credit facility, can you talk to us about what the appropriate level of cash to hold on your balance sheet is at this point?

Malon Wilkus

Honestly, we won't be able to give you much guidance there. We maintained enough cash on our balance sheet to be able to manage the demands that we have on our cash and cash flows. As you know, we generate -- we have been historically generating quite a lot of cash quarterly as a result of realizations off of the portfolio. And we've been making a good number of new investments over the year. But the ability to forecast that is quite lumpy. And so when we have investment opportunities coming up, as you well know, we have our share buyback program underway, and we have other miscellaneous demands and, in part, even the requirement to amortize our debt, we have to manage it carefully. And we have -- in our view, not been -- we have not held more cash on our balance sheet than really is needed to manage through these various cash flow requirements. We -- so I cannot give you an exact number, even a much of a range in that respect.

John R. Erickson

It does change, obviously, based on the pipeline of originations based on how close we are to an amortization payment on debt and those sort of factors. And our view of what exits are likely to occur the next 3 months, 6 months, 12 months.

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Okay, guys. And thanks and appreciate your discussing the buyback in that context. And then one last question, particularly at it relates to stock options. Malon, is it your intention to ask shareholders for an updated stock-based comp plan in the upcoming proxy, now that all the options under the existing plan have been distributed?

Malon Wilkus

No. We really would not be able -- even if our shareholders gave us that approval, we would not be able to grant the options because of the 20% limit that we're subject to as a BDC. And one thing I'll say is that we think our current plans that we have implemented are highly motivating for our shareholders, I should say, for our employees, and I think aligned very clearly with our shareholders. Another point I'll make is that there's been discussion of the degree to which there has been exercise of options. And the most recent calculation that we've done here is that over the past year, only about 4% of our options that were granted in the -- subsequent to 2008, have been exercised by our senior management team.

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Okay, great. And one last technical question, if I may. John, quick question related to the majority-owned portfolio of companies. Could you maybe give us just a view as to what types of companies are pretty darn difficult to get Sar Box [ph] compliant? No names but just the types of businesses that sometime -- the complexities that you run into, to the extent you were going down that DTC route?

John R. Erickson

Yes, look, businesses that operate in 20 different countries and have $100 million of revenues. Those type of businesses are very difficult. And so, I mean, there's a lot of difficulties you would encounter.

Operator

Our next question comes from Greg Mason of Stifel, Nicolaus.

Greg M. Mason - Stifel, Nicolaus & Co., Inc., Research Division

To follow-up on one of John's questions. Malon, last quarter, you talked about the investment opportunities that you were seeing and that the marketplace was pretty competitive. Can you talk about what you're seeing, just in the overall market for new investment opportunities? And are you liking what you're seeing today? And are you able to -- are there a lot of deals out there to do?

Malon Wilkus

I do believe it's still very competitive, and I think the volumes are still at some of the lowest levels since 2007. However, I do feel like the quality has been getting better. And I believe we're seeing more opportunities in the earlier and medium stages. So we're feeling more optimistic about deploying capital, say, than we've had in the last year or so.

Greg M. Mason - Stifel, Nicolaus & Co., Inc., Research Division

Okay, great. And then one last question. Can you give us any update on the timing of the securitizations winding down? Is it still early 2014 expectations for that?

Malon Wilkus

Yes, I think that our historical guidance still holds. I think it would be early 2014 is when we project the last ones to pay down I think you'll see that the balance continues to go down quarter by quarter.

Malon Wilkus

And we should point out which quarter?

John R. Erickson

We expect this quarter to be paying down one of our on balance sheet securitizations.

John R. Erickson

The overall maturity remains the same.

Operator

We have a follow-up question from Angelo Guarino of DTI.

Angelo Guarino

Yes, since in your presentation at -- this kind of follows up on the last question, your presentation at Imperial Capital, there's a lot of discussion about -- in the Q&A about the potential of the REIT structuring and REIT splitting into a holding company. And one of the things that you were talking about was the difficulty of -- so many variety of your companies having to get their accounting systems up to snuff and also get them aligned on the same year. And in the end, Malon, you were talking about that and discussing the difficulties, in the end, you said, yes, but we're working on that. So can we take that away that not saying that you’re actually going to go down that path of restructuring, but you're kind of putting things in place that, that could -- you could be in that position that your control companies are actually trying to align their accounting systems, so that's a possibility?

Malon Wilkus

Yes, our board in the first quarter of this year gave us the direction to bring our control companies up to the public reporting standards, not necessarily all of our control companies, but a good number of them. And so we're working hard on that. We do believe that one option for us is to, not only report our financials on a fair value basis, but also to voluntarily report our financials on a consolidated basis. And so that's one option that we're looking at and we're working hard to be able to accomplish that. But please understand, this is a very substantial task. We have, I believe, about 46 controlled companies. And it's just a huge effort to do the work that's necessary to do public consolidated reporting.

Angelo Guarino

But the work is being done? I mean, you guys are actively...

Malon Wilkus

We're actively working to accomplish that and, along with it, to assess how long it would take to accomplish it.

Angelo Guarino

And then with this new announcement that you made about the infrastructure investment, I know you can't talk about the future funding and such, but how do we think about what you announced, what is it right now? Is it a subsidiary, or is it a business unit of the LLC? I couldn't really pull that out of the press release. As it stands now, what is it?

Malon Wilkus

Paul has joined American Capital, LLC, which is our alternative asset management company. And in our alternative asset management company, there is a variety of subsidiaries, which manage different funds that we manage. So there is a subsidiary that manages our ACE I and ACE II, another subsidiary that manages our CLOs and so forth. And he is the CEO of one of those subsidiaries.

Angelo Guarino

So it's a business unit, basically?

John R. Erickson

If you go back and look, for example, we hired Mark Pelletier in, I think, about 2005 before we ever had a CLO platform. We hired our agency team before we ever raised capital around agency. We hired Jeff Winkler before we ever did MTGEs. So that's just part of the business model, is to find good talent.

Angelo Guarino

Okay. I just should know he was COO of what?

Operator

The conference has now concluded. An archive of this presentation will be available on American Capital's website and the telephone recording of this call can be accessed through November 16 by dialing (877) 344-7529, using the conference ID 10019010. Thank you for joining today's call. You may now disconnect.

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