Allied Capital Goes from Value Trap to Deep Value

Includes: ACAS, AFC, ARCC
by: The Curious Investor

For those that follow this blog, I once wrote about an asset class known as business development companies, particularly middle-market lending BDCs. These businesses typically concentrate on investing through the financing of middle-market private equity transactions. Over the last year, some have come under pressure as a result of government regulations over BDCs which require them to maintain certain asset coverage levels. As a result of the disjunction in the markets, mark-to-market mark downs on BDC portfolios resulted in some BDCs (most recognizably Allied Capital (NYSEARCA:ALD) and American Capital (NASDAQ:ACAS)) falling out of line with asset coverage regulations, tripping debt covenants, and discontinuing dividends.

On Monday, a major shakeup was announced within the BDC industry. Ares Capital (NASDAQ:ARCC), one of a few BDCs which has managed through the recession while maintaining a substantial dividend, announced that it was acquiring a former giant of the industry, Allied Capital (ALD). The acquisition is expected to be an all-stock deal where ALD shareholders will receive 0.325 shares of ARCC for each share of ALD they own.

ALD, which had breached the asset coverage covenants on its debt, has not been able to pay a dividend since the third quarter of 2008. Allied, in fact, has taken almost a year to restructure its debt agreements leading its auditors to issue a “going concern” warning in its 10Qs in each of the last few quarters. While concerns regarding the Company’s debt agreements has weighed down the stock’s value, the Company’s net asset value per share was reported as $7.49 on June 30, 2009 which includes serious write downs taken by the company over the last year.

Why then does the stock trade at 43% of NAV/share? For one, questions about the Company’s continued ability to access financing make it difficult to handicap whether or not Allied will ever have the luxury of time to “wait” for its investments to mature and be refinanced. In fact, pressure to de-lever has already forced the Company to make hundreds of millions of dollars in distressed investment sales over the year. Further, the Company has a history of questions being raised over the quality of Allied’s investments and its methodology for establishing fair value for its reporting. (See David Einhorn’s Fooling Some of the People All of the Time)

With all these headwinds facing the Company and the difficulty that the average investor would have verifying the Company’s portfolio quality, Allied was more likely a value trap than a good value investment even at <45% of NAV. But, all that has changed now that Ares Capital has decided to swoop in and acquire Allied. Ares Capital Corporation is one of few BDCs which has weathered the recent recession without having to suspend its dividend and has not seen outsized portfolio market value depreciation. Further, it is managed by Ares Management, a distant descendant of Leon Black’s famed private equity shop, Apollo Management. While a good investor should always do his own due diligence, Ares’ vote of confidence likely goes a long way to provide an investor some comfort with Allied’s current stock valuation.

Further, given Allied’s troubles securing affordable financing and continued portfolio difficulties, Allied has little incentive not to close this transaction (though some shareholders seem to disagree). As there’s a high likelihood of completion (currently expected to close 1Q 2010), there seems to be a quasi-arbitrage opportunity presented by ALD shares and value investor’s dream opportunity to enter into ARCC shares.

As mentioned above each ALD share will be exchanged for 0.325 shares of ARCC. ARCC and ALD closed today at $10.61 and $3.20, respectively. As such, if the deal were completed today, ALD shareholders should receive the equivalent of $3.44 per share in ARCC stock which implies that ALD is currently trading at a 7.75% discount. Now, if you’re not interested in investing in the BDC space and simply would like to take advantage of this pricing irregularity, you could buy ALD and short ARCC and simply wait to pocket the spread – a “riskless” arbitrage of this merger. (Caveat being that if the merger falls apart the whole thing blows up in your face.)

But, I believe that ALD’s current discount is even more compelling from a value standpoint. By my estimates based on June 30, 2009 reporting, the combined Allied and Ares should have a net asset value around $15.30/share. At today’s $10.61 closing price, Ares is trading at just 70% of combined entity NAV and at 95% of its own reported NAV of $11.05 (post a recent dilutive share offering). This would seem a pretty good discount for a BDC which has proven its ability to manage through a very difficult market environment and a demonstrated ability to access financing, the key trait necessary to realize value from Allied Capital’s portfolio.

But, you don’t have to settle for ARCC’s discount to NAV. As mentioned earlier, ALD trades at a near 8% discount to its conversion price. So, by just purchasing ALD shares today, you can enter ARCC at a below market value discount at a significant discount simply for taking on 6 months of risk as the merger approaches its closing. Is it worth it? More diligence probably needs to be given to Ares’ debt portfolio, but I would say on the surface ALD shares have gotten significantly more appealing.

Full Disclosure: Author has no position in the stocks mentioned in this post.