AMERICAN CAPITAL LTD ACAS
January 22, 2015 - 2:42pm EST by
rsm
2015 2016
Price: 14.35 EPS 0 0
Shares Out. (in M): 269 P/E 0 0
Market Cap (in $M): 3,869 P/FCF 0 0
Net Debt (in $M): 918 EBIT 0 0
TEV ($): 4,787 TEV/EBIT 0 0

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  • BDC
  • restructuring
  • Discount to NAV
  • Potential Spin-Off
  • Sum Of The Parts (SOTP)
  • Special Situation
 

Description

 

Target Price 20.00
52 Week Range 13.59-16.37
Div. Yield 0%
Short Interest 1.5%
   
Hard Catalyst Spin
Timing 9 months

Buy American Capital Ltd. - The Street is Blinded by ACAS’s History

American Capital’s recent history is not pretty: it’s a busted Business Development Company (BDC) which last restructured in Q2’10. The company has stopped paying dividends, and is trading at a 30% discount to its USD20.54 NAV.

The Street has been burnt by management’s slow progress; however, ACAS turned the corner, when the board approved management’s plan to spin out two new BDC’s. I use a sum of the parts valuation to show that the restructure and spin will unlock value and create 40% upside in 9 months. The Street is blind to the fact that the tide has turned for American Capital.

                ACAS is Unloved by Dividend and Special Situation Funds

Dividend investors, the natural buyers of BDC’s, have no interest in ACAS which last paid a dividend in Q4’08. Instead of paying dividends, management has returned significant amounts of cash to shareholders through share buy backs.

In April 2014 the company announced that it was planning to restructure and the stock traded up 11% on the day to USD15.80. Special situation and event-driven investors, who would ordinarily jump into a stock like ACAS, have become wary of the company because it took management a further 8 months to release details of the spin and it took a total of 9 months for the plan to receive board approval.

ACAS is out of favor with all of the natural buyers which creates a great opportunity to buy at a significant discount. Shares will trade up towards their USD20 value when management announces a definitive date for the spin. I expect the spin to take place in 3Q’15 and for further details to be publicly available this summer.

                ACAS’s Portfolio Transformation is Misunderstood

The restructure is messy and revolves around a number of tax and regulatory requirements. The Regulated Investment Company (RIC) regulations set strict limits on the assets which can be held by a BDC. In order to obtain tax-advantaged RIC status, management has transformed ACAS from a highly leveraged book of CLO equity, middle market private equity buyouts and subordinated securities into a book where almost 55% of fair value is tied up in RIC friendly senior floating rate debt. The market has not recognized this change or given management credit for the increased quality of the firm’s assets.

                ACAS’s Spin-Off is Partially Taxable

Management expects that the spin-off of one BDC will be tax-free, and that one spin-off will be taxable. This is an added cost and complexity which may put off some investors. While I believe that the tax cost to most investors will be zero, the tax on this transaction could be as much as USD0.75 per share.

The Spin-off

The board has approved plans to transform American Capital Ltd (ACAS) into a standalone investment manager and to spin the assets currently held at American Capital Ltd. into two new BDC’s. Post-spin, the shareholders will hold shares in three listed entities which should be valued at USD20. The current share price is USD14.20 and the additional value is driven by:

                American Capital Ltd (ACAS)                                                                  +USD1.21 per share

ACAS will cease to invest on its own balance sheet (with a couple of temporary exceptions) and become a pure play investment manager. Post-spin ACAS will replace American Capital Asset Management LLC as asset manager for the American Capital private equity funds, listed REITS and CLO’s.

ACAS will be valued at 13x EV/EBIT post-spin (see page 10 for details on the expected multiple). In addition, management will achieve the targeted cost reductions of USD25MM p.a. and receive the expected reimbursements of USD46MM p.a. from the new Spin Co’s ACI and ACG&I. ACAS will retain its USD434MM tax asset.

                European Capital                                                                                     +USD0.65 per share

The proposed restructuring will not affect the European Capital fund. American Capital Ltd. is currently the investment manager and only investor in the European Capital fund and this will remain the case post-spin.

In Dec. 2014 European Capital sold its largest portfolio company Farrow & Ball which accounted for around 25% of fair value. This transaction substantially reduced the risk in the European Capital book and demonstrated management’s ability to realize significant profits. Farrow & Ball was sold for around USD430MM which was more than 20% above marked fair value. This transaction and other sales at European Capital lead me to expect that the fund will be valued at NAV by the market post-spin. Ultimately, management is likely to spin-out European Capital or open it to outside investors.

                Spin Co 1 - American Capital Growth & Income (ACG&I)                    +USD2.56 per share

ACG&I will be managed by ACAS and will focus on American Capital led buyouts, senior floating rate loans and hold the portfolio of CLO equity. The company will be taxed as a RIC and will pay an 8-10% dividend

ACG&I will hold around USD1.6bn in senior bank loans and USD1.4bn in buy-out investments previously made by American Capital. The BDC will continue to invest in new private equity deals sponsored by American Capital. While the valuation, transparency and liquidity of the bank loan book will be good under all reasonable scenarios, it is very difficult for outside investors to value the fund’s private equity investments.

I expect that the bank loan book will be valued at NAV by the market and that the private equity portfolio will be valued at a 20-30% discount to NAV. This discount is in line with the discounts I see on other similar assets, including the private equity investments at European Capital and Prospect Capital Corporation. ACG&I will trade at a 10% discount to NAV post-spin.

                Spin Co 2 - American Capital Income (ACI)                                            +USD1.54 per share

ACI will be managed by ACAS and will focus on lending to third-party buyouts. The company will be taxed as a RIC and will pay an 8-10% dividend. This spin-off is expected to be taxable. Given the wide range of possible tax rates, I do not attempt to estimate tax payable; however, I estimate the taxable income to be USD1.81 per share based on a USD14.20 purchase price.

The ACI portfolio will be a typical book of middle market loans and will have a diversified mix of non-control/non-affiliate debt and equity investments. The fund’s portfolio will be very similar to the one held by Golub Capital and as a result, I expect ACI to trade at NAV like Golub Capital.

Risks

The key risks are:

-ACG&I and ACI fail to earn tax-advantaged Regulated Investment Company status

-ACI and ACG&I fail to obtain sufficient leverage (I expect 0.6:1 Debt-to-Equity) or the covenants on the debt are overly restrictive 

-with the exception of the energy industry (ACAS has relatively low exposure to energy), defaults are expected to remain low in 2015. An increase in defaults could result in pre-spin losses at ACAS or write downs at ACI and ACG&I post-spin

-ACAS’s mortgage funds (NASDAQ: AGNC and NASDAQ: MTGE) account for the bulk of the pre-spin fees. Any disruption to the REIT or mortgage market would have a negative impact on ACAS’s valuation. 

-a general sell off of BDC’s and asset managers may increase the NAV discount and decrease the EV/EBIT multiple applied to the asset manager

Current Business

ACAS originates, underwrites and manages middle-market private equity buy-outs, buys structured products and makes loans to a range of businesses. ACAS has USD21bn in assets under management including USD7bn at ACAS and USD14bn of externally managed capital in 9 private and 3 listed funds. In addition to being a BDC, ACAS was a RIC when it IPO’ed in 1997 and was one of the biggest and most active, publicly traded, buyout and mezzanine lending firms prior to 2008.

     Discount to NAV

ACAS currently trades at a 30% discount to its USD20.54 NAV which is a large discount compared to the firm’s peers. American Capital trades at a large discount because the firm:

     1-has relatively poor asset quality and had large write downs (more than USD1bn) in 2009/10

     2-pays no dividend

     3-has lost its RIC status and is subject to federal taxation

Fig 1: NAV Discount of BDC Company Peers

 

Latest

2013

2012

2011

ACAS

-31%

-18%

-28%

-53%

Golub Capital

3%

14%

9%

2%

Prospect Capital Corporation

-5%

1%

5%

-2%

FS Investment Corporation

6%

n.a.

n.a.

n.a.

Apollo Investment Corporation

-6%

1%

-16%

20%

Fifth Street Finance Corp.

-5%

5%

11%

-7%

   Industry Median

-8%

-2%

4%

-16%

   Industry Minimum

-34%

-37%

-438%

-56%

     Asset Quality

In 2008 ACAS reported USD3.4bn in unrealized losses. The company went on to realize USD1.4bn of losses in 2009 and 2010. ACAS currently has the poorest asset quality (as measured by non-accrual loans as a percentage of fair value) of the major BDC’s. While Fifth Street Finance Corp. had a similar level of troubled loans in 2009, Fifth Street management has substantially reduced their exposure to non-accrual loans.

Fig 2: Non-Accrual Loans as a % of Fair Value

 

30-Sep-14

2013

2012

2011

2010

2009

ACAS

5.7%

9.7%

9.0%

8.7%

7.8%

7.8%

Golub Capital

0.0%

0.1%

0.5%

0.6%

0.9%

n.a.

Prospect Capital Corporation

0.1%

0.1%

1.9%

3.5%

4.1%

5.8%

FS Investment Corporation

0.5%

0.0%

0.0%

n.a.

n.a.

n.a.

Apollo Investment Corporation

0.4%

0.4%

0.3%

0.2%

2.0%

1.5%

Fifth Street Finance Corp.

0.3%

2.0%

2.0%

2.0%

5.0%

7.0%

   Industry Median

0.3%

0.3%

1.2%

2.0%

4.1%

6.4%

      Loss of RIC Status and Current Taxation

From 1997 to 30-Sep-2010, ACAS was taxed as a RIC under Subchapter M of the Internal Revenue Code. RIC’s, like REITS, are not subject to federal income tax on income and capital gains which are distributed to shareholders; however, RIC’s are subject to a number of restrictions and are not permitted to carry forward NOL’s.

ACAS dropped its RIC designation in September 2010 and is currently taxed as a C corporation. This change allowed the firm to preserve USD786MM in net loss carry-forwards (USD434MM in deferred tax assets) which were accumulated during 2008/09. ACAS’s tax status does not affect its status as a BDC.

     Dividend Payments

With the exception of ACAS, the BDC’s listed below are all RIC’s and, as a result, are required to pay out 90% of their income to shareholders in order to retain their tax advantaged status. 

Fig 3: Dividend Yields of Selected BDC Peers

 

Latest

2013

2012

2011

2010

2009

2008

2007

ACAS

0%

0%

0%

0%

0%

0%

0%

13%

Golub Capital

7%

7%

8%

8%

7%

0%

0%

0%

Prospect Capital Corporation

12%

12%

12%

13%

11%

14%

14%

12%

FS Investment Corporation

9%

0%

0%

0%

0%

0%

0%

0%

Apollo Investment Corporation

11%

9%

10%

17%

10%

12%

22%

12%

Fifth Street Finance Corp.

14%

12%

11%

12%

11%

10%

18%

0%

   Industry Median

10%

9%

10%

11%

8%

11%

18%

11%

     Third Party Funds Managed by American Capital Asset Management

 American Capital Asset Management (ACAM) currently manages 12 funds and CLO’s which will be managed by ACAS post-spin.

Fig 4: Funds Managed by ACAM

Name

Type

Size

Mgmt. Fee

Incentive Fee

American Capital Equity I

Private equity fund

USD0.5bn AUM

Up to 2%

Up to 30%

American Capital Equity II

Private equity fund

USD0.2bn AUM

Up to 2%

Up to 35%

American Capital Equity III

Private equity fund

USD0.6bn AUM

Up to 2%

Up to 20%

European Capital

Private equity fund

USD1bn AUM

Wholly-owned by ACAS

None

American Capital Agency

NASDAQ: AGNC

USD62.3bn of AUM

1.25% of equity

None

American Capital Mortgage Investment

NASDAQ: MTGE

USD7.1bn of AUM

1.50% of equity

None

American Capital Structured Finance

NASDAQ: ACSF

USD0.3bn of AUM

0.80% of AUM

None

ACAS CLO 2007-1

CLO

USD0.4bn AUM

0.68%

20%

ACAS CLO 2012-1

CLO

USD0.4bn AUM

0.42%

20%

ACAS CLO 2013-1

CLO

USD0.4bn AUM

0.50%

20%

ACAS CLO 2013-2

CLO

USD0.4bn AUM

0.42%

20%

ACAS CLO 2014-1

CLO

USD0.6bn AUM

0.50%

20%

 European Capital makes equity, mezzanine and senior debt investments in Europe. European Capital and its manager European Capital Asset Management Limited are both wholly-owned affiliates of American Capital, Ltd. European Capital follows a similar strategy to ACAS (invests in private and public companies and private equity buyouts); however, European Capital is not eligible for tax preferred RIC status.

Post-Spin Valuation

In order to value ACAS post-spin we must: a) determine the fair value of the BDC’s and their likely premium or discount to NAV and b) value the new management company.

     Reasonableness of Current NAV and Asset Fair Value

BDC’s such as ACAS are required to ensure that at least 70% of their assets are ‘qualified’. Qualified assets are illiquid securities of small and medium-sized companies. This asset mix makes it difficult for outsiders to determine true fair value. American Capital is doubly difficult because it also acts as a financial sponsor and uses its BDC as a private equity buyout fund. I will attempt to form a view on fair value by assessing the reasonableness of management’s valuation inputs.

BDC’s are regulated under the ’40 Act and are not required to create a general loss reserve like a bank. ACAS is required to mark its investments at fair value. Accounting Series Release 118 recommends determining fair value by using:

     -an earnings multiple

     -a discount to the market price of a similar liquid security

     -yield-to-maturity

     -or, helpfully, another method

          First Lien Loans and Senior Debt

If we use yield as a proxy for risk ACAS’s first lien book has a similar risk to the leveraged loan market as a whole. ACAS’s first lien loans yielded 4.7% at 3Q’14 which is close to the 2 year average yield of the LevLoan 100 index. The yield on the LevLoan index rose at year end 2014 which would imply a decline in the value of ACAS’s loan book during Q4’14. Based on yield, the risk of ACAS’s senior loan book is in line with its peers

Fig 5: ACAS Senior Debt Yield Compared to Peers

Mkt Yield - Senior Debt

Min.

Max.

Average

ACAS

5%

19%

10%

Golub

5%

34%

7%

Prospect

6%

21%

11%

FS Investment

5%

12%

9%

Apollo

7%

20%

13%

Fifth Street Finance

n.a.

n.a.

n.a.

At 3Q’14 the total senior/first lien book had a fair value of USD2.3bn. ACAS generated around USD2bn in cash in the first 3 quarters of 2014 and bought USD1.6bn of senior floating rate loans. These new loans, which account for almost 70% of the current loan book, are representative of market pricing and terms at the time they were written. As a result, I expect that the market will value the loan book at NAV post-spin.

          Mezzanine Debt

If yield is a proxy for risk, ACAS’s mezz book (USD548MM at cost and USD392MM at fair value) is materially more risky than its peers. Around 45% of mezz loans are classified as non-accrual and PIK principal appears to be USD115MM. Reasonable investors would apply a large NAV discount to the PIKing and non-accrual loans in the mezz book.

Fig 6: ACAS Yield on Mezz Debt Compared to Peers

Mkt Yield - Mezzanine Debt

Min.

Max.

Average

ACAS

15%

18%

16%

Golub

9%

12%

9%

Prospect

8%

15%

11%

FS Investment

9%

18%

11%

Apollo

n.a.

n.a.

n.a.

Fifth Street Finance

n.a.

n.a.

n.a.

The vast majority of ACAS’s mezz investments are related to ACAS’s buy-out investments. In the run up to the spin, ACAS’s management are likely to reduce their exposure to sponsored private equity investments and mezz debt. I expect that the market will value the mezz book at a 20% discount to NAV in line with its valuation of ACAS’s other control investments.

          Preference Shares

The preferred book relates primarily to control investments made by ACAS’s buy-out team. While there is limited information available on valuation metrics used by ACAS’s peers to value preference shares, we can infer that ACAS’s books is significantly more risky than Apollo’s.

Fig 7: ACAS Yield on Preferred Shares Compared to Peers

Mkt Yield - Preferred Equity

Min.

Max.

Average

ACAS

16%

26%

24%

Golub

n.a.

n.a.

n.a.

Prospect

n.a.

n.a.

n.a.

FS Investment

n.a.

n.a.

n.a.

Apollo

13%

18%

14%

Fifth Street Finance

n.a.

n.a.

n.a.

ACAS’s management mark the preference share book at USD150MM (cost USD153MM). The fair value of the largest preference share position is USD90MM; however, the median position size is USD3.5MM. As a result of its size, I expect that the preferred book will be largely ignored by the market; however, I value it at a 20% discount to NAV.

          Equity

ACAS does not provide sufficient information to determine the reasonableness of the valuations in its equity book. While the average discount rate of 15% (see Fig. 9) may be reasonable, the minimum discount rate of 4% is inappropriate for any equity other than a cash box with a finite life. The average terminal growth rate of 3% is probably ACAS’s estimate of long term US GDP growth and seems reasonable. While I would love to invest in a business which can grow at grow at 7% in perpetuity, I think that the maximum terminal value is absurd.

The 20% discount to traded companies seems reasonable, while the 30% premium may be the result of a small sample size or differing growth rates. The average control premium of 8% seems low, I would have expected the average premium to be in the region of 15%. The use of a sales multiple is interesting and is typically used for to value unprofitable businesses. Broadly speaking, the average metrics appear reasonable; however, a reasonable investor would value the equity book at a 20-30% discount to NAV to reflect the risk and illiquidity associated with the equity of private middle market companies. 

Fig 9:8ACAS Equity Valuation Methods and Metrics

Valuation Method

Metric

Min.

Max.

Average

Enterprise discounted cash flow

Discount rate

4%

58%

15%

 

Terminal value growth rate

2%

7%

3%

Public comparable companies

Discount to traded comparables (multiples)

-55%

30%

-19%

 

Control premium

0%

22%

8%

Sales of comparable companies

Discount to traded comparables (multiples)

-45%

5%

-17%

          Structured Products (CLO’s and CMBS)

ACAS’s CLO book is broadly priced in line with its peers.

Fig 9: ACAS Yield on CLO’s and CMBS Compared to Peers

Mkt Yield - Structured Products

Min.

Max.

Average

ACAS

5%

107%

13%

Golub

n.a.

n.a.

n.a.

Prospect

6%

20%

15%

FS Investment

11%

12%

12%

Apollo

11%

15%

12%

Fifth Street Finance

13%

14%

14%

Fig 10: CDR and CPR Estimates

ACAS CLO Book

Min.

Max.

Average

 

Blackstone CLO Book

Min.

Max.

Average

Constant Prepayment Rate

30.0%

35.0%

31.0%

 

Constant Prepayment Rate

5.0%

20.0%

18.0%

Constant Default Rate

0.0%

2.0%

1.0%

 

Constant Default Rate

2.0%

3.0%

2.1%

ACAS’s management provide some additional color on their CLO book including the Constant Prepayment Rate (CPR) and Constant Default Rate (CDR). The average CDR of 1% is low; however, this figure is in line with current default levels (the long term average CDR should be at least 3-4%). The average CPR is very high and implies that large amounts of cash are being spun off by the CLO book.

An inflated CPR will increase the value of both the senior and equity tranches (cash will be returned sooner than anticipated). An artificially low CDR will also increase the value of the senior tranches by a little and equity tranches by a lot. Without the servicer certificates or Bloomberg or Intex, it’s impossible to determine whether ACAS’s valuations are reasonable; however, I believe that the average CDR is too low. Many of ACAS’s CLO investments are 2006, 2007 and 2008 vintage and many older loans were refinanced during 2014. While refinancing activity was high in 2014, it is unreasonable to assume that refinancing will continue at the same rate.

The current fair value of ACG&I’s CLO equity book (subordinate notes) is USD221MM and the fair value of ACI’s CLO book is USD146MM. I think that management is overstating the fair value of its CLO investments especially the CLO equity held by ACG&I. I value the CLO equity book at a 20% discount to NAV and ACI’s CLO book at a 5% discount to NAV.

          Loan Defaults and Non-Accruals: Leveraged Loan Defaults

According to S&P/LCD’s latest quarterly buy-side survey (Dec. 2014) the average buy side manager expects that the default rate will be 1.64% in 2015 and 2.52% in 2016. This compares favorably with a 2014 default rate of 3.25%. When considering the 3.25% default rate it is important to note that the Energy Future Holdings (EFH) default increased the default rate by 3.5% when it filed for bankruptcy in April. Excluding EFH the default rate for 2014 was around 1%.

          Loan Defaults and Non-Accruals: HY Bond Defaults

The junk bond default rate for 2014 is around 2% according to Moody's who expect the default rate to remain around 2% in 1H’15. However, Energy companies constitute around 17% of the high-yield bond market and a sustained decline in the price of oil may lead to a sharp increase in default rates.

          Current Industry Exposure

ACAS’s portfolio is largely diversified and investors have limited exposure to oil prices.

Fig 11: ACAS Portfolio Exposures by Industry

Industry

Fair Value

 

Industry

Fair Value

Capital Markets (CLO’s)

24 %

 

Diversified Consumer Services

3%

Life Sciences Tools and Services

11%

 

Professional Services

3%

Commercial Services and Supplies

4%

 

Auto Components

3%

Health Care Providers and Services

3%

 

Health Care Equipment and Supplies

2%

Electronic Equipment, Instruments and Components

3%

 

Food Products

2%

Media

3%

 

Oil, Gas and Consumable Fuels

2%

IT Services

3%

 

Aerospace and Defense

2%

Hotels and Leisure

3%

 

Other

9%

          CLO Tranches and Energy Industry Risk

S&P surveyed 700 CLO’s and found that the average CLO had 3.3% exposure to energy which is much lower than energy exposure in the junk bond market as a whole. The tranched nature of a CLO means that any losses will hit the lower tranches first. Without access to Bloomberg or Intex it is not possible to assess the impact of the energy related losses on the tranches held by ACAS; however, 2013/14 vintage CLO’s are likely to have high (~20%) exposure to energy.

         Expected Dividend Payments

Prior to 2008, ACAS was simply one of many listed BDC’s. The company traded at around 1.3x NAV as investors bought the dividend without regard to the underlying value. In 2009/10 ACAS was forced to make more than USD1bn in write downs, cut its dividend to zero and restructure its debt obligations. As a result of the dividend cut ACAS lost its tax advantaged RIC status and convert to a C Corp. for tax purposes.

As a C Corp., management began using cash flow to buy back 1/3 of outstanding shares and pay down debt rather than pay dividends. Management expect that both ACGI and ACI will pay a ‘market rate’ dividend; however, this assumes that ACGI and ACI will have access to debt financing. BDC’s are limited by statute to 1x debt-to-equity and ACAS’s current covenants limit the debt to equity ratio to 0.75:1. I expect that ACG&I and ACI will be managed with a debt-to-equity ratio of between 0.5:1 and 0.75:1. Both ACG&I and ACI should be able to pay out a dividend in the region of 8-10% which is in line with the dividends paid by the other major BDC’s and management guidance. I do not expect ACAS to pay a dividend. 

Fig 12: Return Earned at Various Levels of Leverage Given the Current Asset Mix

 

Post Spin

Average

Leverage

 

Equity

Interest Rate

0.25:1

0.5:1

0.75:1

1.0:1

ACG&I

3,134

5.6%

6.8%

8.1%

9.5%

10.8%

ACI

1,034

9.1%

11.0%

13.2%

15.4%

17.6%

     Management Company (ACAS) Valuation

The restructuring means that, post-spin, fee income will replace interest and dividends as the primary sources of income. In line with management’s assertion that both ACG&I and ACI will pay market standard fees I assume:

                ACG&I                  -2% management fee and a 20% performance fee subject to a 8% hurdle rate

                                            -60% Debt to Equity

                                            -returns based on current asset mix (5.2%) and adjusted for leverage

                ACI                        -1% management fee and a 20% performance fee subject to a 8% hurdle rate

                                             -60% Debt to Equity

                                             -returns based on current assets (6.8%) and adjusted for leverage

Of the USD14bn in third party fee earning funds under management USD3.5bn (25%) are funds with finite lives (CLO’s and private equity funds). Three of the funds with USD1.1bn of fee paying capital have finite lives and were launched during or before 2007 which means that the vast bulk of ACAS’s fee earning assets are either long term, or permanent. Post-spin, almost 80% of fee earning assets will be permanent which gives investors a great deal of security around fee revenue.

USD25MM of current SG&A is for the benefit of assets which will be held by ACI and ACG&I. ACAS will continue to incur these costs and will be reimbursed by ACI and ACG&I. In addition, USD21MM of costs incurred by ACAS are related to the provision of services and advice to portfolio companies which will be spun out into ACI and ACG&I. These costs will also be reimbursed. Management has also instituted a cost savings program and expect to achieve cost savings of around USD25MM p.a. by the end of 2015.

I expect debt to be reduced to around 500MM which will be used primarily to fund the purchase of loans for ACAS’s CLO program. I assume American Capital creates one new CLO per year.

Fig 13: ACAS Financials

ACAS Income Statement

(USD MM's)

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

Fee Income

84

59

54

48

60

60

109

253

290

302

314

326

Interest and Dividend Income

950

638

546

543

586

423

351

91

12

12

12

12

Reimbursement and Other Revenue

17

0

0

0

0

0

0

35

46

46

46

46

   Total Revenue

1,051

697

600

591

646

483

460

378

347

360

372

384

                         

Compensation

(206)

(215)

(134)

(143)

(148)

(156)

(142)

(142)

(156)

(161)

(166)

(171)

General and Administrative

(95)

(94)

(64)

(55)

(56)

(55)

(52)

(56)

(58)

(60)

(61)

(62)

   EBIT b/f Investment Gains

750

388

402

393

442

272

266

180

133

139

145

151

                         

   EBIT

(2,804)

(674)

1,175

636

1,176

277

532

180

133

139

145

151

   EBITDA

(2,772)

(643)

1,200

666

1,192

290

536

184

138

144

150

156

                         

Interest

(220)

(256)

(177)

(90)

(59)

(44)

(53)

(54)

(32)

(27)

(23)

(23)

   Earnings b/f Tax

(3,024)

(930)

998

546

1,117

233

479

126

101

112

122

128

                         

Income Tax

(91)

20

0

428

19

(53)

7

0

0

0

0

0

   Net Income

(3,115)

(910)

998

974

1,136

180

486

126

101

112

122

128

 

 

 

 

 

 

 

 

 

 

 

 

 

EPS

-$15.22

-$3.76

$2.92

$2.85

$3.57

$0.54

$1.84

$0.47

$0.38

$0.42

$0.46

$0.48

EPS Diluted

 

 

 

 

 

 

 

$0.39

$0.32

$0.35

$0.38

$0.40

          Recent Asset Manager Spin-Offs and IPO’s

While the proposed ACAS spin transaction is unique, there are a number of recent asset management company spin-offs which give investors a glimpse into how the management company may trade post-spin.

Fig 14: Recent Comparable Asset Management Transactions

Name

Ticker

Description

Northstar Asset Management

 

 

 

NYSE: NSAM

 

 

 

-spin-off to shareholders

-manages a REIT, healthcare, hotel and manufactured housing make up 90% of value

-20 year management contracts which are only terminable for cause

-184x EV/LTM EBIT

Fifth Street Asset Management

 

 

 

NASDAQ: FSAM

 

 

 

-IPO not spin

-manages 2 public BDC’s, CLO’s and a credit hedge fund

-float is only 12%, average traded value is USD5MM per day

-6x EV/LTM EBIT

Medley Management

 

 

 

NYSE: MDLY

 

 

 

-IPO not spin

-manages 1 listed and 1 private BDC, 1/6th the fee paying assets of ACAS

-current NAV adj. for dilution is 10.25, 10% discount to NAV

-21x EV/EBIT

          ACAS Multiple

While the three managers above trade between 6-184x EV/EBIT, the major asset managers trade with multiples between 7-15x EV/EBIT. I believe that post-spin ACAS should be valued with a 13x multiple which is reasonable given the valuations of NSAM, FSAM and MDLY.

Fig 15: ACAS Post-Spin Equity Value

 

EV/EBIT Multiple

   

EBIT

9x

11x

13x

15x

17x

120

518

754

990

1,226

1,462

130

608

864

1,120

1,376

1,632

138

698

974

1,250

1,526

1,802

150

788

1,084

1,380

1,676

1,972

160

878

1,194

1,510

1,826

2,142

The 13x multiple is justified by the diversified (mortgage REIT, BDC, CLO and private equity) and largely permanent (almost 80% of fee paying assets are in permanent capital vehicles) nature of the funds which will be managed by ACAS post-spin. ACAS typically renews the management contracts with its permanent capital funds annually. In the event that ACAS is replaced as manager, the fund will typically pay a termination fee equal to 3 years of management fees (3-6% of fee paying assets). This termination fee is a substantial penalty, and I do not expect ACAS to be replaced as manager of its funds.

The 13x multiple is significantly less than the 21x multiple applied to MDLY and the insane 184x multiple applied to NSAM. FSAM is so thinly traded that the valuation is meaningless.'

     European Capital Valuation

While ACAS’s non-accrual book remains large compared to ACAS’s peers, management is improving its credit exposure by buying first lien loans and reducing its equity risk. ACAS’s European Capital fund reduced its equity exposure by 59% in December 2014 when it sold the paint manufacture Farrow & Ball.

At 3Q’14 European Capital had a NAV of USD766MM and was carried on ACAS’s books at USD678MM an 11% discount. Farrow & Ball was valued at USD331MM and sold at USD433MM a +23% premium to NAV. The fact that management was able to realize more than NAV for a buy-out investment like Farrow & Ball gives me confidence around management’s ability to sell risky buy-out investments for at least NAV.

Management has made comments to the effect that European Capital may sell its remaining equity investments and transform its self into a European debt fund. Ultimately, ACAS is likely to spin out European Capital or open it to third party investors at NAV. This would be a positive development for ACAS shareholders as it would eliminate the NAV discount and generate fees in the region of 1.5/20%. The base case scenario is that European Capital will trade at NAV.

Fig 16: Estimated Value of European Capital

 

European Capital Discount to NAV

NAV

10%

5%

0%

550

495

523

550

610

549

580

610

680

612

646

680

750

675

713

750

830

747

789

830

     American Capital Growth & Income (ACG&I)

ACG&I’s portfolio will hold the debt and equity related to American Capital’s buyouts and ACAS’s senior floating rate loan portfolio. While the senior loan book should be valued by the market at NAV, the market is likely to place a discount on the USD750MM in buyouts and higher risk investments. The base case scenario (in grey) is that ACG&I will trade at a 10% discount to NAV.

Fig 17: Estimated Value of ACG&I

 

ACG&I Discount to NAV

NAV

20%

15%

10%

5%

0%

2,210

1,768

1,879

1,989

2,100

2,210

2,450

1,960

2,083

2,205

2,328

2,450

2,720

2,176

2,312

2,448

2,584

2,720

2,990

2,392

2,542

2,691

2,841

2,990

3,290

2,632

2,797

2,961

3,126

3,290

     American Capital Income (ACI)

ACI’s portfolio is relatively transparent and should be more liquid than the buy-out assets held at ACG&I. For the reasons outlined above, the base case scenario (in grey) is that ACI will trade at NAV.

Fig 18: Estimated Value of ACI

 

ACI Discount to NAV

NAV

10%

5%

0%

1,330

1,197

1,264

1,330

1,480

1,332

1,406

1,480

1,640

1,476

1,558

1,640

1,800

1,620

1,710

1,800

1,980

1,782

1,881

1,980

          Tax Impact of ACI Spin

As per management’s comments, ACG&I will be a tax free spin (it owns operating businesses through ACAS’s buyout business); however, ACI is a pure investment company and will therefore be taxable. Under Section 355 of the Internal Revenue Code, spin-offs are considered tax-free if they meet a range of requirements including that the parent and spin-co are engaged in an "active trade or business". As per § 1.355-3 (iv) (A) the active conduct of a trade or business does not include "the holding for investment purposes of stock, securities, land, or other property".

               Cost Basis Calculation

If an investor buys one share of company ACAS at USD14.20 and receives one share of ACI and ACG&I they will have to pay tax on a portion of their investment in ACI. If we assume that all three entities trade as expected immediately after the spin, the worst case scenario is that taxable income is USD1.81 per share.

Fig 19: Estimated Taxable Income per Share (USD14.20 Purchase Price)

 

Value

Cost Basis

Taxable Income

ACAS

4.62

3.27

0.00

ACI

6.19

4.38

1.81

ACG&I

9.24

6.54

0.00

Base Case Value

20.05

   

     Dilution

ACAS has issued options over 54MM shares to management with strike prices from USD0.94 to USD49.63. While the maximum dilution is 54MM shares, the wide range of strike prices mean that dilution is likely to be less than 53MM shares. The exercise of all options with a strike of less than USD20 (53MM shares) will raise USD431MM in cash or ACAS.

Under the ‘40 Act, the number of options that can be outstanding is limited to no more than 20% of the outstanding shares of the company. ACAS has issued options on shares equal to just less than 20% and is therefore unable to further dilute shareholders.

Sum of the Parts Valuation

The table below outlines the sum of the parts valuation of USD20.20 for ACAS, ACI and ACG&I post-spin.

Fig 20: Post-Spin Sum of the Parts Valuation

 

  ACAS Equity Value      
EBIT 9x 11x 13x 15x 17x
120 500 732 964 1,196 1,428
130 590 842 1,094 1,346 1,598
136 680 952 1,224 1,496 1,768
150 770 1,062 1,354 1,646 1,938
160 860 1,172 1,484 1,796 2,108
           
  Spin Co - ACG&I      
  ACG&I Discount to NAV    
NAV 20% 15% 10% 5% 0%
2,210 1,768 1,879 1,989 2,100 2,210
2,450 1,960 2,083 2,205 2,328 2,450
2,720 2,176 2,312 2,448 2,584 2,720
2,990 2,392 2,542 2,691 2,841 2,990
3,290 2,632 2,797 2,961 3,126 3,290
           
  Spin Co - ACI      
  ACI Discount to NAV      
NAV 10% 5% 0% 0% 0%
1,330 1,197 1,264 1,330 1,330 1,330
1,480 1,332 1,406 1,480 1,480 1,480
1,640 1,476 1,558 1,640 1,640 1,640
1,800 1,620 1,710 1,800 1,800 1,800
1,980 1,782 1,881 1,980 1,980 1,980
           
  European Capital      
  European Capital Discount to NAV  
NAV 10% 5% 0% 0% 0%
550 495 523 550 550 550    
610 549 580 610 610 610    
680 612 646 680 680 680    
750 675 713 750 750 750    
830 747 789 830 830 830    
           
  Post-Spin Equity Value    
   Worst Case
Downside
Base Case  Upside  Best Case
 Worst Case
13.81 15.18         16.56      17.63    
18.71    
Downside 15.29 16.80         18.31      19.48    
20.66    
Base Case 16.91 18.55         20.20      21.48    
22.77    
 Upside 18.52 20.31         22.10      23.49    
24.87    
Best Case
20.29 22.23         24.17      25.67    
27.17    
 
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

1-management set a date for the spin and release additional information
2-management continue to realize marked fair value on their asset sales and use the proceeds to buy senior debt

    sort by    

    Description

     

    Target Price 20.00
    52 Week Range 13.59-16.37
    Div. Yield 0%
    Short Interest 1.5%
       
    Hard Catalyst Spin
    Timing 9 months

    Buy American Capital Ltd. - The Street is Blinded by ACAS’s History

    American Capital’s recent history is not pretty: it’s a busted Business Development Company (BDC) which last restructured in Q2’10. The company has stopped paying dividends, and is trading at a 30% discount to its USD20.54 NAV.

    The Street has been burnt by management’s slow progress; however, ACAS turned the corner, when the board approved management’s plan to spin out two new BDC’s. I use a sum of the parts valuation to show that the restructure and spin will unlock value and create 40% upside in 9 months. The Street is blind to the fact that the tide has turned for American Capital.

                    ACAS is Unloved by Dividend and Special Situation Funds

    Dividend investors, the natural buyers of BDC’s, have no interest in ACAS which last paid a dividend in Q4’08. Instead of paying dividends, management has returned significant amounts of cash to shareholders through share buy backs.

    In April 2014 the company announced that it was planning to restructure and the stock traded up 11% on the day to USD15.80. Special situation and event-driven investors, who would ordinarily jump into a stock like ACAS, have become wary of the company because it took management a further 8 months to release details of the spin and it took a total of 9 months for the plan to receive board approval.

    ACAS is out of favor with all of the natural buyers which creates a great opportunity to buy at a significant discount. Shares will trade up towards their USD20 value when management announces a definitive date for the spin. I expect the spin to take place in 3Q’15 and for further details to be publicly available this summer.

                    ACAS’s Portfolio Transformation is Misunderstood

    The restructure is messy and revolves around a number of tax and regulatory requirements. The Regulated Investment Company (RIC) regulations set strict limits on the assets which can be held by a BDC. In order to obtain tax-advantaged RIC status, management has transformed ACAS from a highly leveraged book of CLO equity, middle market private equity buyouts and subordinated securities into a book where almost 55% of fair value is tied up in RIC friendly senior floating rate debt. The market has not recognized this change or given management credit for the increased quality of the firm’s assets.

                    ACAS’s Spin-Off is Partially Taxable

    Management expects that the spin-off of one BDC will be tax-free, and that one spin-off will be taxable. This is an added cost and complexity which may put off some investors. While I believe that the tax cost to most investors will be zero, the tax on this transaction could be as much as USD0.75 per share.

    The Spin-off

    The board has approved plans to transform American Capital Ltd (ACAS) into a standalone investment manager and to spin the assets currently held at American Capital Ltd. into two new BDC’s. Post-spin, the shareholders will hold shares in three listed entities which should be valued at USD20. The current share price is USD14.20 and the additional value is driven by:

                    American Capital Ltd (ACAS)                                                                  +USD1.21 per share

    ACAS will cease to invest on its own balance sheet (with a couple of temporary exceptions) and become a pure play investment manager. Post-spin ACAS will replace American Capital Asset Management LLC as asset manager for the American Capital private equity funds, listed REITS and CLO’s.

    ACAS will be valued at 13x EV/EBIT post-spin (see page 10 for details on the expected multiple). In addition, management will achieve the targeted cost reductions of USD25MM p.a. and receive the expected reimbursements of USD46MM p.a. from the new Spin Co’s ACI and ACG&I. ACAS will retain its USD434MM tax asset.

                    European Capital                                                                                     +USD0.65 per share

    The proposed restructuring will not affect the European Capital fund. American Capital Ltd. is currently the investment manager and only investor in the European Capital fund and this will remain the case post-spin.

    In Dec. 2014 European Capital sold its largest portfolio company Farrow & Ball which accounted for around 25% of fair value. This transaction substantially reduced the risk in the European Capital book and demonstrated management’s ability to realize significant profits. Farrow & Ball was sold for around USD430MM which was more than 20% above marked fair value. This transaction and other sales at European Capital lead me to expect that the fund will be valued at NAV by the market post-spin. Ultimately, management is likely to spin-out European Capital or open it to outside investors.

                    Spin Co 1 - American Capital Growth & Income (ACG&I)                    +USD2.56 per share

    ACG&I will be managed by ACAS and will focus on American Capital led buyouts, senior floating rate loans and hold the portfolio of CLO equity. The company will be taxed as a RIC and will pay an 8-10% dividend

    ACG&I will hold around USD1.6bn in senior bank loans and USD1.4bn in buy-out investments previously made by American Capital. The BDC will continue to invest in new private equity deals sponsored by American Capital. While the valuation, transparency and liquidity of the bank loan book will be good under all reasonable scenarios, it is very difficult for outside investors to value the fund’s private equity investments.

    I expect that the bank loan book will be valued at NAV by the market and that the private equity portfolio will be valued at a 20-30% discount to NAV. This discount is in line with the discounts I see on other similar assets, including the private equity investments at European Capital and Prospect Capital Corporation. ACG&I will trade at a 10% discount to NAV post-spin.

                    Spin Co 2 - American Capital Income (ACI)                                            +USD1.54 per share

    ACI will be managed by ACAS and will focus on lending to third-party buyouts. The company will be taxed as a RIC and will pay an 8-10% dividend. This spin-off is expected to be taxable. Given the wide range of possible tax rates, I do not attempt to estimate tax payable; however, I estimate the taxable income to be USD1.81 per share based on a USD14.20 purchase price.

    The ACI portfolio will be a typical book of middle market loans and will have a diversified mix of non-control/non-affiliate debt and equity investments. The fund’s portfolio will be very similar to the one held by Golub Capital and as a result, I expect ACI to trade at NAV like Golub Capital.

    Risks

    The key risks are:

    -ACG&I and ACI fail to earn tax-advantaged Regulated Investment Company status

    -ACI and ACG&I fail to obtain sufficient leverage (I expect 0.6:1 Debt-to-Equity) or the covenants on the debt are overly restrictive 

    -with the exception of the energy industry (ACAS has relatively low exposure to energy), defaults are expected to remain low in 2015. An increase in defaults could result in pre-spin losses at ACAS or write downs at ACI and ACG&I post-spin

    -ACAS’s mortgage funds (NASDAQ: AGNC and NASDAQ: MTGE) account for the bulk of the pre-spin fees. Any disruption to the REIT or mortgage market would have a negative impact on ACAS’s valuation. 

    -a general sell off of BDC’s and asset managers may increase the NAV discount and decrease the EV/EBIT multiple applied to the asset manager

    Current Business

    ACAS originates, underwrites and manages middle-market private equity buy-outs, buys structured products and makes loans to a range of businesses. ACAS has USD21bn in assets under management including USD7bn at ACAS and USD14bn of externally managed capital in 9 private and 3 listed funds. In addition to being a BDC, ACAS was a RIC when it IPO’ed in 1997 and was one of the biggest and most active, publicly traded, buyout and mezzanine lending firms prior to 2008.

         Discount to NAV

    ACAS currently trades at a 30% discount to its USD20.54 NAV which is a large discount compared to the firm’s peers. American Capital trades at a large discount because the firm:

         1-has relatively poor asset quality and had large write downs (more than USD1bn) in 2009/10

         2-pays no dividend

         3-has lost its RIC status and is subject to federal taxation

    Fig 1: NAV Discount of BDC Company Peers

     

    Latest

    2013

    2012

    2011

    ACAS

    -31%

    -18%

    -28%

    -53%

    Golub Capital

    3%

    14%

    9%

    2%

    Prospect Capital Corporation

    -5%

    1%

    5%

    -2%

    FS Investment Corporation

    6%

    n.a.

    n.a.

    n.a.

    Apollo Investment Corporation

    -6%

    1%

    -16%

    20%

    Fifth Street Finance Corp.

    -5%

    5%

    11%

    -7%

       Industry Median

    -8%

    -2%

    4%

    -16%

       Industry Minimum

    -34%

    -37%

    -438%

    -56%

         Asset Quality

    In 2008 ACAS reported USD3.4bn in unrealized losses. The company went on to realize USD1.4bn of losses in 2009 and 2010. ACAS currently has the poorest asset quality (as measured by non-accrual loans as a percentage of fair value) of the major BDC’s. While Fifth Street Finance Corp. had a similar level of troubled loans in 2009, Fifth Street management has substantially reduced their exposure to non-accrual loans.

    Fig 2: Non-Accrual Loans as a % of Fair Value

     

    30-Sep-14

    2013

    2012

    2011

    2010

    2009

    ACAS

    5.7%

    9.7%

    9.0%

    8.7%

    7.8%

    7.8%

    Golub Capital

    0.0%

    0.1%

    0.5%

    0.6%

    0.9%

    n.a.

    Prospect Capital Corporation

    0.1%

    0.1%

    1.9%

    3.5%

    4.1%

    5.8%

    FS Investment Corporation

    0.5%

    0.0%

    0.0%

    n.a.

    n.a.

    n.a.

    Apollo Investment Corporation

    0.4%

    0.4%

    0.3%

    0.2%

    2.0%

    1.5%

    Fifth Street Finance Corp.

    0.3%

    2.0%

    2.0%

    2.0%

    5.0%

    7.0%

       Industry Median

    0.3%

    0.3%

    1.2%

    2.0%

    4.1%

    6.4%

          Loss of RIC Status and Current Taxation

    From 1997 to 30-Sep-2010, ACAS was taxed as a RIC under Subchapter M of the Internal Revenue Code. RIC’s, like REITS, are not subject to federal income tax on income and capital gains which are distributed to shareholders; however, RIC’s are subject to a number of restrictions and are not permitted to carry forward NOL’s.

    ACAS dropped its RIC designation in September 2010 and is currently taxed as a C corporation. This change allowed the firm to preserve USD786MM in net loss carry-forwards (USD434MM in deferred tax assets) which were accumulated during 2008/09. ACAS’s tax status does not affect its status as a BDC.

         Dividend Payments

    With the exception of ACAS, the BDC’s listed below are all RIC’s and, as a result, are required to pay out 90% of their income to shareholders in order to retain their tax advantaged status. 

    Fig 3: Dividend Yields of Selected BDC Peers

     

    Latest

    2013

    2012

    2011

    2010

    2009

    2008

    2007

    ACAS

    0%

    0%

    0%

    0%

    0%

    0%

    0%

    13%

    Golub Capital

    7%

    7%

    8%

    8%

    7%

    0%

    0%

    0%

    Prospect Capital Corporation

    12%

    12%

    12%

    13%

    11%

    14%

    14%

    12%

    FS Investment Corporation

    9%

    0%

    0%

    0%

    0%

    0%

    0%

    0%

    Apollo Investment Corporation

    11%

    9%

    10%

    17%

    10%

    12%

    22%

    12%

    Fifth Street Finance Corp.

    14%

    12%

    11%

    12%

    11%

    10%

    18%

    0%

       Industry Median

    10%

    9%

    10%

    11%

    8%

    11%

    18%

    11%

         Third Party Funds Managed by American Capital Asset Management

     American Capital Asset Management (ACAM) currently manages 12 funds and CLO’s which will be managed by ACAS post-spin.

    Fig 4: Funds Managed by ACAM

    Name

    Type

    Size

    Mgmt. Fee

    Incentive Fee

    American Capital Equity I

    Private equity fund

    USD0.5bn AUM

    Up to 2%

    Up to 30%

    American Capital Equity II

    Private equity fund

    USD0.2bn AUM

    Up to 2%

    Up to 35%

    American Capital Equity III

    Private equity fund

    USD0.6bn AUM

    Up to 2%

    Up to 20%

    European Capital

    Private equity fund

    USD1bn AUM

    Wholly-owned by ACAS

    None

    American Capital Agency

    NASDAQ: AGNC

    USD62.3bn of AUM

    1.25% of equity

    None

    American Capital Mortgage Investment

    NASDAQ: MTGE

    USD7.1bn of AUM

    1.50% of equity

    None

    American Capital Structured Finance

    NASDAQ: ACSF

    USD0.3bn of AUM

    0.80% of AUM

    None

    ACAS CLO 2007-1

    CLO

    USD0.4bn AUM

    0.68%

    20%

    ACAS CLO 2012-1

    CLO

    USD0.4bn AUM

    0.42%

    20%

    ACAS CLO 2013-1

    CLO

    USD0.4bn AUM

    0.50%

    20%

    ACAS CLO 2013-2

    CLO

    USD0.4bn AUM

    0.42%

    20%

    ACAS CLO 2014-1

    CLO

    USD0.6bn AUM

    0.50%

    20%

     European Capital makes equity, mezzanine and senior debt investments in Europe. European Capital and its manager European Capital Asset Management Limited are both wholly-owned affiliates of American Capital, Ltd. European Capital follows a similar strategy to ACAS (invests in private and public companies and private equity buyouts); however, European Capital is not eligible for tax preferred RIC status.

    Post-Spin Valuation

    In order to value ACAS post-spin we must: a) determine the fair value of the BDC’s and their likely premium or discount to NAV and b) value the new management company.

         Reasonableness of Current NAV and Asset Fair Value

    BDC’s such as ACAS are required to ensure that at least 70% of their assets are ‘qualified’. Qualified assets are illiquid securities of small and medium-sized companies. This asset mix makes it difficult for outsiders to determine true fair value. American Capital is doubly difficult because it also acts as a financial sponsor and uses its BDC as a private equity buyout fund. I will attempt to form a view on fair value by assessing the reasonableness of management’s valuation inputs.

    BDC’s are regulated under the ’40 Act and are not required to create a general loss reserve like a bank. ACAS is required to mark its investments at fair value. Accounting Series Release 118 recommends determining fair value by using:

         -an earnings multiple

         -a discount to the market price of a similar liquid security

         -yield-to-maturity

         -or, helpfully, another method

              First Lien Loans and Senior Debt

    If we use yield as a proxy for risk ACAS’s first lien book has a similar risk to the leveraged loan market as a whole. ACAS’s first lien loans yielded 4.7% at 3Q’14 which is close to the 2 year average yield of the LevLoan 100 index. The yield on the LevLoan index rose at year end 2014 which would imply a decline in the value of ACAS’s loan book during Q4’14. Based on yield, the risk of ACAS’s senior loan book is in line with its peers

    Fig 5: ACAS Senior Debt Yield Compared to Peers

    Mkt Yield - Senior Debt

    Min.

    Max.

    Average

    ACAS

    5%

    19%

    10%

    Golub

    5%

    34%

    7%

    Prospect

    6%

    21%

    11%

    FS Investment

    5%

    12%

    9%

    Apollo

    7%

    20%

    13%

    Fifth Street Finance

    n.a.

    n.a.

    n.a.

    At 3Q’14 the total senior/first lien book had a fair value of USD2.3bn. ACAS generated around USD2bn in cash in the first 3 quarters of 2014 and bought USD1.6bn of senior floating rate loans. These new loans, which account for almost 70% of the current loan book, are representative of market pricing and terms at the time they were written. As a result, I expect that the market will value the loan book at NAV post-spin.

              Mezzanine Debt

    If yield is a proxy for risk, ACAS’s mezz book (USD548MM at cost and USD392MM at fair value) is materially more risky than its peers. Around 45% of mezz loans are classified as non-accrual and PIK principal appears to be USD115MM. Reasonable investors would apply a large NAV discount to the PIKing and non-accrual loans in the mezz book.

    Fig 6: ACAS Yield on Mezz Debt Compared to Peers

    Mkt Yield - Mezzanine Debt

    Min.

    Max.

    Average

    ACAS

    15%

    18%

    16%

    Golub

    9%

    12%

    9%

    Prospect

    8%

    15%

    11%

    FS Investment

    9%

    18%

    11%

    Apollo

    n.a.

    n.a.

    n.a.

    Fifth Street Finance

    n.a.

    n.a.

    n.a.

    The vast majority of ACAS’s mezz investments are related to ACAS’s buy-out investments. In the run up to the spin, ACAS’s management are likely to reduce their exposure to sponsored private equity investments and mezz debt. I expect that the market will value the mezz book at a 20% discount to NAV in line with its valuation of ACAS’s other control investments.

              Preference Shares

    The preferred book relates primarily to control investments made by ACAS’s buy-out team. While there is limited information available on valuation metrics used by ACAS’s peers to value preference shares, we can infer that ACAS’s books is significantly more risky than Apollo’s.

    Fig 7: ACAS Yield on Preferred Shares Compared to Peers

    Mkt Yield - Preferred Equity

    Min.

    Max.

    Average

    ACAS

    16%

    26%

    24%

    Golub

    n.a.

    n.a.

    n.a.

    Prospect

    n.a.

    n.a.

    n.a.

    FS Investment

    n.a.

    n.a.

    n.a.

    Apollo

    13%

    18%

    14%

    Fifth Street Finance

    n.a.

    n.a.

    n.a.

    ACAS’s management mark the preference share book at USD150MM (cost USD153MM). The fair value of the largest preference share position is USD90MM; however, the median position size is USD3.5MM. As a result of its size, I expect that the preferred book will be largely ignored by the market; however, I value it at a 20% discount to NAV.

              Equity

    ACAS does not provide sufficient information to determine the reasonableness of the valuations in its equity book. While the average discount rate of 15% (see Fig. 9) may be reasonable, the minimum discount rate of 4% is inappropriate for any equity other than a cash box with a finite life. The average terminal growth rate of 3% is probably ACAS’s estimate of long term US GDP growth and seems reasonable. While I would love to invest in a business which can grow at grow at 7% in perpetuity, I think that the maximum terminal value is absurd.

    The 20% discount to traded companies seems reasonable, while the 30% premium may be the result of a small sample size or differing growth rates. The average control premium of 8% seems low, I would have expected the average premium to be in the region of 15%. The use of a sales multiple is interesting and is typically used for to value unprofitable businesses. Broadly speaking, the average metrics appear reasonable; however, a reasonable investor would value the equity book at a 20-30% discount to NAV to reflect the risk and illiquidity associated with the equity of private middle market companies. 

    Fig 9:8ACAS Equity Valuation Methods and Metrics

    Valuation Method

    Metric

    Min.

    Max.

    Average

    Enterprise discounted cash flow

    Discount rate

    4%

    58%

    15%

     

    Terminal value growth rate

    2%

    7%

    3%

    Public comparable companies

    Discount to traded comparables (multiples)

    -55%

    30%

    -19%

     

    Control premium

    0%

    22%

    8%

    Sales of comparable companies

    Discount to traded comparables (multiples)

    -45%

    5%

    -17%

              Structured Products (CLO’s and CMBS)

    ACAS’s CLO book is broadly priced in line with its peers.

    Fig 9: ACAS Yield on CLO’s and CMBS Compared to Peers

    Mkt Yield - Structured Products

    Min.

    Max.

    Average

    ACAS

    5%

    107%

    13%

    Golub

    n.a.

    n.a.

    n.a.

    Prospect

    6%

    20%

    15%

    FS Investment

    11%

    12%

    12%

    Apollo

    11%

    15%

    12%

    Fifth Street Finance

    13%

    14%

    14%

    Fig 10: CDR and CPR Estimates

    ACAS CLO Book

    Min.

    Max.

    Average

     

    Blackstone CLO Book

    Min.

    Max.

    Average

    Constant Prepayment Rate

    30.0%

    35.0%

    31.0%

     

    Constant Prepayment Rate

    5.0%

    20.0%

    18.0%

    Constant Default Rate

    0.0%

    2.0%

    1.0%

     

    Constant Default Rate

    2.0%

    3.0%

    2.1%

    ACAS’s management provide some additional color on their CLO book including the Constant Prepayment Rate (CPR) and Constant Default Rate (CDR). The average CDR of 1% is low; however, this figure is in line with current default levels (the long term average CDR should be at least 3-4%). The average CPR is very high and implies that large amounts of cash are being spun off by the CLO book.

    An inflated CPR will increase the value of both the senior and equity tranches (cash will be returned sooner than anticipated). An artificially low CDR will also increase the value of the senior tranches by a little and equity tranches by a lot. Without the servicer certificates or Bloomberg or Intex, it’s impossible to determine whether ACAS’s valuations are reasonable; however, I believe that the average CDR is too low. Many of ACAS’s CLO investments are 2006, 2007 and 2008 vintage and many older loans were refinanced during 2014. While refinancing activity was high in 2014, it is unreasonable to assume that refinancing will continue at the same rate.

    The current fair value of ACG&I’s CLO equity book (subordinate notes) is USD221MM and the fair value of ACI’s CLO book is USD146MM. I think that management is overstating the fair value of its CLO investments especially the CLO equity held by ACG&I. I value the CLO equity book at a 20% discount to NAV and ACI’s CLO book at a 5% discount to NAV.

              Loan Defaults and Non-Accruals: Leveraged Loan Defaults

    According to S&P/LCD’s latest quarterly buy-side survey (Dec. 2014) the average buy side manager expects that the default rate will be 1.64% in 2015 and 2.52% in 2016. This compares favorably with a 2014 default rate of 3.25%. When considering the 3.25% default rate it is important to note that the Energy Future Holdings (EFH) default increased the default rate by 3.5% when it filed for bankruptcy in April. Excluding EFH the default rate for 2014 was around 1%.

              Loan Defaults and Non-Accruals: HY Bond Defaults

    The junk bond default rate for 2014 is around 2% according to Moody's who expect the default rate to remain around 2% in 1H’15. However, Energy companies constitute around 17% of the high-yield bond market and a sustained decline in the price of oil may lead to a sharp increase in default rates.

              Current Industry Exposure

    ACAS’s portfolio is largely diversified and investors have limited exposure to oil prices.

    Fig 11: ACAS Portfolio Exposures by Industry

    Industry

    Fair Value

     

    Industry

    Fair Value

    Capital Markets (CLO’s)

    24 %

     

    Diversified Consumer Services

    3%

    Life Sciences Tools and Services

    11%

     

    Professional Services

    3%

    Commercial Services and Supplies

    4%

     

    Auto Components

    3%

    Health Care Providers and Services

    3%

     

    Health Care Equipment and Supplies

    2%

    Electronic Equipment, Instruments and Components

    3%

     

    Food Products

    2%

    Media

    3%

     

    Oil, Gas and Consumable Fuels

    2%

    IT Services

    3%

     

    Aerospace and Defense

    2%

    Hotels and Leisure

    3%

     

    Other

    9%

              CLO Tranches and Energy Industry Risk

    S&P surveyed 700 CLO’s and found that the average CLO had 3.3% exposure to energy which is much lower than energy exposure in the junk bond market as a whole. The tranched nature of a CLO means that any losses will hit the lower tranches first. Without access to Bloomberg or Intex it is not possible to assess the impact of the energy related losses on the tranches held by ACAS; however, 2013/14 vintage CLO’s are likely to have high (~20%) exposure to energy.

             Expected Dividend Payments

    Prior to 2008, ACAS was simply one of many listed BDC’s. The company traded at around 1.3x NAV as investors bought the dividend without regard to the underlying value. In 2009/10 ACAS was forced to make more than USD1bn in write downs, cut its dividend to zero and restructure its debt obligations. As a result of the dividend cut ACAS lost its tax advantaged RIC status and convert to a C Corp. for tax purposes.

    As a C Corp., management began using cash flow to buy back 1/3 of outstanding shares and pay down debt rather than pay dividends. Management expect that both ACGI and ACI will pay a ‘market rate’ dividend; however, this assumes that ACGI and ACI will have access to debt financing. BDC’s are limited by statute to 1x debt-to-equity and ACAS’s current covenants limit the debt to equity ratio to 0.75:1. I expect that ACG&I and ACI will be managed with a debt-to-equity ratio of between 0.5:1 and 0.75:1. Both ACG&I and ACI should be able to pay out a dividend in the region of 8-10% which is in line with the dividends paid by the other major BDC’s and management guidance. I do not expect ACAS to pay a dividend. 

    Fig 12: Return Earned at Various Levels of Leverage Given the Current Asset Mix

     

    Post Spin

    Average

    Leverage

     

    Equity

    Interest Rate

    0.25:1

    0.5:1

    0.75:1

    1.0:1

    ACG&I

    3,134

    5.6%

    6.8%

    8.1%

    9.5%

    10.8%

    ACI

    1,034

    9.1%

    11.0%

    13.2%

    15.4%

    17.6%

         Management Company (ACAS) Valuation

    The restructuring means that, post-spin, fee income will replace interest and dividends as the primary sources of income. In line with management’s assertion that both ACG&I and ACI will pay market standard fees I assume:

                    ACG&I                  -2% management fee and a 20% performance fee subject to a 8% hurdle rate

                                                -60% Debt to Equity

                                                -returns based on current asset mix (5.2%) and adjusted for leverage

                    ACI                        -1% management fee and a 20% performance fee subject to a 8% hurdle rate

                                                 -60% Debt to Equity

                                                 -returns based on current assets (6.8%) and adjusted for leverage

    Of the USD14bn in third party fee earning funds under management USD3.5bn (25%) are funds with finite lives (CLO’s and private equity funds). Three of the funds with USD1.1bn of fee paying capital have finite lives and were launched during or before 2007 which means that the vast bulk of ACAS’s fee earning assets are either long term, or permanent. Post-spin, almost 80% of fee earning assets will be permanent which gives investors a great deal of security around fee revenue.

    USD25MM of current SG&A is for the benefit of assets which will be held by ACI and ACG&I. ACAS will continue to incur these costs and will be reimbursed by ACI and ACG&I. In addition, USD21MM of costs incurred by ACAS are related to the provision of services and advice to portfolio companies which will be spun out into ACI and ACG&I. These costs will also be reimbursed. Management has also instituted a cost savings program and expect to achieve cost savings of around USD25MM p.a. by the end of 2015.

    I expect debt to be reduced to around 500MM which will be used primarily to fund the purchase of loans for ACAS’s CLO program. I assume American Capital creates one new CLO per year.

    Fig 13: ACAS Financials

    ACAS Income Statement

    (USD MM's)

    2008

    2009

    2010

    2011

    2012

    2013

    2014

    2015

    2016

    2017

    2018

    2019

    Fee Income

    84

    59

    54

    48

    60

    60

    109

    253

    290

    302

    314

    326

    Interest and Dividend Income

    950

    638

    546

    543

    586

    423

    351

    91

    12

    12

    12

    12

    Reimbursement and Other Revenue

    17

    0

    0

    0

    0

    0

    0

    35

    46

    46

    46

    46

       Total Revenue

    1,051

    697

    600

    591

    646

    483

    460

    378

    347

    360

    372

    384

                             

    Compensation

    (206)

    (215)

    (134)

    (143)

    (148)

    (156)

    (142)

    (142)

    (156)

    (161)

    (166)

    (171)

    General and Administrative

    (95)

    (94)

    (64)

    (55)

    (56)

    (55)

    (52)

    (56)

    (58)

    (60)

    (61)

    (62)

       EBIT b/f Investment Gains

    750

    388

    402

    393

    442

    272

    266

    180

    133

    139

    145

    151

                             

       EBIT

    (2,804)

    (674)

    1,175

    636

    1,176

    277

    532

    180

    133

    139

    145

    151

       EBITDA

    (2,772)

    (643)

    1,200

    666

    1,192

    290

    536

    184

    138

    144

    150

    156

                             

    Interest

    (220)

    (256)

    (177)

    (90)

    (59)

    (44)

    (53)

    (54)

    (32)

    (27)

    (23)

    (23)

       Earnings b/f Tax

    (3,024)

    (930)

    998

    546

    1,117

    233

    479

    126

    101

    112

    122

    128

                             

    Income Tax

    (91)

    20

    0

    428

    19

    (53)

    7

    0

    0

    0

    0

    0

       Net Income

    (3,115)

    (910)

    998

    974

    1,136

    180

    486

    126

    101

    112

    122

    128

     

     

     

     

     

     

     

     

     

     

     

     

     

    EPS

    -$15.22

    -$3.76

    $2.92

    $2.85

    $3.57

    $0.54

    $1.84

    $0.47

    $0.38

    $0.42

    $0.46

    $0.48

    EPS Diluted

     

     

     

     

     

     

     

    $0.39

    $0.32

    $0.35

    $0.38

    $0.40

              Recent Asset Manager Spin-Offs and IPO’s

    While the proposed ACAS spin transaction is unique, there are a number of recent asset management company spin-offs which give investors a glimpse into how the management company may trade post-spin.

    Fig 14: Recent Comparable Asset Management Transactions

    Name

    Ticker

    Description

    Northstar Asset Management

     

     

     

    NYSE: NSAM

     

     

     

    -spin-off to shareholders

    -manages a REIT, healthcare, hotel and manufactured housing make up 90% of value

    -20 year management contracts which are only terminable for cause

    -184x EV/LTM EBIT

    Fifth Street Asset Management

     

     

     

    NASDAQ: FSAM

     

     

     

    -IPO not spin

    -manages 2 public BDC’s, CLO’s and a credit hedge fund

    -float is only 12%, average traded value is USD5MM per day

    -6x EV/LTM EBIT

    Medley Management

     

     

     

    NYSE: MDLY

     

     

     

    -IPO not spin

    -manages 1 listed and 1 private BDC, 1/6th the fee paying assets of ACAS

    -current NAV adj. for dilution is 10.25, 10% discount to NAV

    -21x EV/EBIT

              ACAS Multiple

    While the three managers above trade between 6-184x EV/EBIT, the major asset managers trade with multiples between 7-15x EV/EBIT. I believe that post-spin ACAS should be valued with a 13x multiple which is reasonable given the valuations of NSAM, FSAM and MDLY.

    Fig 15: ACAS Post-Spin Equity Value

     

    EV/EBIT Multiple

       

    EBIT

    9x

    11x

    13x

    15x

    17x

    120

    518

    754

    990

    1,226

    1,462

    130

    608

    864

    1,120

    1,376

    1,632

    138

    698

    974

    1,250

    1,526

    1,802

    150

    788

    1,084

    1,380

    1,676

    1,972

    160

    878

    1,194

    1,510

    1,826

    2,142

    The 13x multiple is justified by the diversified (mortgage REIT, BDC, CLO and private equity) and largely permanent (almost 80% of fee paying assets are in permanent capital vehicles) nature of the funds which will be managed by ACAS post-spin. ACAS typically renews the management contracts with its permanent capital funds annually. In the event that ACAS is replaced as manager, the fund will typically pay a termination fee equal to 3 years of management fees (3-6% of fee paying assets). This termination fee is a substantial penalty, and I do not expect ACAS to be replaced as manager of its funds.

    The 13x multiple is significantly less than the 21x multiple applied to MDLY and the insane 184x multiple applied to NSAM. FSAM is so thinly traded that the valuation is meaningless.'

         European Capital Valuation

    While ACAS’s non-accrual book remains large compared to ACAS’s peers, management is improving its credit exposure by buying first lien loans and reducing its equity risk. ACAS’s European Capital fund reduced its equity exposure by 59% in December 2014 when it sold the paint manufacture Farrow & Ball.

    At 3Q’14 European Capital had a NAV of USD766MM and was carried on ACAS’s books at USD678MM an 11% discount. Farrow & Ball was valued at USD331MM and sold at USD433MM a +23% premium to NAV. The fact that management was able to realize more than NAV for a buy-out investment like Farrow & Ball gives me confidence around management’s ability to sell risky buy-out investments for at least NAV.

    Management has made comments to the effect that European Capital may sell its remaining equity investments and transform its self into a European debt fund. Ultimately, ACAS is likely to spin out European Capital or open it to third party investors at NAV. This would be a positive development for ACAS shareholders as it would eliminate the NAV discount and generate fees in the region of 1.5/20%. The base case scenario is that European Capital will trade at NAV.

    Fig 16: Estimated Value of European Capital

     

    European Capital Discount to NAV

    NAV

    10%

    5%

    0%

    550

    495

    523

    550

    610

    549

    580

    610

    680

    612

    646

    680

    750

    675

    713

    750

    830

    747

    789

    830

         American Capital Growth & Income (ACG&I)

    ACG&I’s portfolio will hold the debt and equity related to American Capital’s buyouts and ACAS’s senior floating rate loan portfolio. While the senior loan book should be valued by the market at NAV, the market is likely to place a discount on the USD750MM in buyouts and higher risk investments. The base case scenario (in grey) is that ACG&I will trade at a 10% discount to NAV.

    Fig 17: Estimated Value of ACG&I

     

    ACG&I Discount to NAV

    NAV

    20%

    15%

    10%

    5%

    0%

    2,210

    1,768

    1,879

    1,989

    2,100

    2,210

    2,450

    1,960

    2,083

    2,205

    2,328

    2,450

    2,720

    2,176

    2,312

    2,448

    2,584

    2,720

    2,990

    2,392

    2,542

    2,691

    2,841

    2,990

    3,290

    2,632

    2,797

    2,961

    3,126

    3,290

         American Capital Income (ACI)

    ACI’s portfolio is relatively transparent and should be more liquid than the buy-out assets held at ACG&I. For the reasons outlined above, the base case scenario (in grey) is that ACI will trade at NAV.

    Fig 18: Estimated Value of ACI

     

    ACI Discount to NAV

    NAV

    10%

    5%

    0%

    1,330

    1,197

    1,264

    1,330

    1,480

    1,332

    1,406

    1,480

    1,640

    1,476

    1,558

    1,640

    1,800

    1,620

    1,710

    1,800

    1,980

    1,782

    1,881

    1,980

              Tax Impact of ACI Spin

    As per management’s comments, ACG&I will be a tax free spin (it owns operating businesses through ACAS’s buyout business); however, ACI is a pure investment company and will therefore be taxable. Under Section 355 of the Internal Revenue Code, spin-offs are considered tax-free if they meet a range of requirements including that the parent and spin-co are engaged in an "active trade or business". As per § 1.355-3 (iv) (A) the active conduct of a trade or business does not include "the holding for investment purposes of stock, securities, land, or other property".

                   Cost Basis Calculation

    If an investor buys one share of company ACAS at USD14.20 and receives one share of ACI and ACG&I they will have to pay tax on a portion of their investment in ACI. If we assume that all three entities trade as expected immediately after the spin, the worst case scenario is that taxable income is USD1.81 per share.

    Fig 19: Estimated Taxable Income per Share (USD14.20 Purchase Price)

     

    Value

    Cost Basis

    Taxable Income

    ACAS

    4.62

    3.27

    0.00

    ACI

    6.19

    4.38

    1.81

    ACG&I

    9.24

    6.54

    0.00

    Base Case Value

    20.05

       

         Dilution

    ACAS has issued options over 54MM shares to management with strike prices from USD0.94 to USD49.63. While the maximum dilution is 54MM shares, the wide range of strike prices mean that dilution is likely to be less than 53MM shares. The exercise of all options with a strike of less than USD20 (53MM shares) will raise USD431MM in cash or ACAS.

    Under the ‘40 Act, the number of options that can be outstanding is limited to no more than 20% of the outstanding shares of the company. ACAS has issued options on shares equal to just less than 20% and is therefore unable to further dilute shareholders.

    Sum of the Parts Valuation

    The table below outlines the sum of the parts valuation of USD20.20 for ACAS, ACI and ACG&I post-spin.

    Fig 20: Post-Spin Sum of the Parts Valuation

     

      ACAS Equity Value      
    EBIT 9x 11x 13x 15x 17x
    120 500 732 964 1,196 1,428
    130 590 842 1,094 1,346 1,598
    136 680 952 1,224 1,496 1,768
    150 770 1,062 1,354 1,646 1,938
    160 860 1,172 1,484 1,796 2,108
               
      Spin Co - ACG&I      
      ACG&I Discount to NAV    
    NAV 20% 15% 10% 5% 0%
    2,210 1,768 1,879 1,989 2,100 2,210
    2,450 1,960 2,083 2,205 2,328 2,450
    2,720 2,176 2,312 2,448 2,584 2,720
    2,990 2,392 2,542 2,691 2,841 2,990
    3,290 2,632 2,797 2,961 3,126 3,290
               
      Spin Co - ACI      
      ACI Discount to NAV      
    NAV 10% 5% 0% 0% 0%
    1,330 1,197 1,264 1,330 1,330 1,330
    1,480 1,332 1,406 1,480 1,480 1,480
    1,640 1,476 1,558 1,640 1,640 1,640
    1,800 1,620 1,710 1,800 1,800 1,800
    1,980 1,782 1,881 1,980 1,980 1,980
               
      European Capital      
      European Capital Discount to NAV  
    NAV 10% 5% 0% 0% 0%
    550 495 523 550 550 550    
    610 549 580 610 610 610    
    680 612 646 680 680 680    
    750 675 713 750 750 750    
    830 747 789 830 830 830    
               
      Post-Spin Equity Value    
       Worst Case
    Downside
    Base Case  Upside  Best Case
     Worst Case
    13.81 15.18         16.56      17.63    
    18.71    
    Downside 15.29 16.80         18.31      19.48    
    20.66    
    Base Case 16.91 18.55         20.20      21.48    
    22.77    
     Upside 18.52 20.31         22.10      23.49    
    24.87    
    Best Case
    20.29 22.23         24.17      25.67    
    27.17    
     
    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    1-management set a date for the spin and release additional information
    2-management continue to realize marked fair value on their asset sales and use the proceeds to buy senior debt

    Messages


    SubjectNew ACAS
    Entry01/23/2015 03:58 PM
    Memberjuice835

    thanks for the write-up.

    I don't necessarily agree that the new ACAS entity ought get a 13x EBIT multiple in part from its diversification. Isn't it's management of AGNC the virtual entirety of current earnings (80%?) in that segment? Look at what happened to the whole of ACAS' stock when the first FED "tapering" was announced and AGNC went down. Also, when we spoke to the company we were concerned that expenses in that segment would be high as that's where the current ACAS mgmt team will have the majority of their comp paid from and that that could offset a lot of the cost savings. have you discussed this with them?


    SubjectRe: ACAS: few questions
    Entry01/25/2015 08:16 AM
    Memberrsm

    Ivampa1070,

    The idea is that the spin creates two tax efficient BDC’s and allows what will become the management company to keep their tax assets (RIC's typically can't carry forward NOL's). At the same time the spin should create BDC’s which are more attractive to two different types of investors.

     

    There will be a change in cash flows, the 2 new BDC’s will pay dividends. Fees (management and incentive) and reimbursements will be paid by the BDC’s to the new management company and as part of the restructuring management is cutting costs (workforce cut by 13% on Oct. 24). And the new management company will continue to benefit from its tax assets.

    ACAS has bought back $1.3bn in stock since 2011. If we say mgmt. could have paid a dividend with that cash then we get 5.8% (2011), 9.4% (2012), 12.3% (2013) and 7% YTD 30-Sep-2014. If you search for fig. 12 you see that 8-10% div. can be paid with 0.5:1 leverage given the current asset mix.

    If you look at fig. 20 I have ACAS equity value of $1.2bn post-spin. That’s 13 x EBIT of 136 – 500MM in debt. ACAS is going warehouse some loans which will go into new CLO’s and seed new funds (which is what ACAM is currently doing) so there will be a need for equity and ~$500MM post-spin debt at ACAS.

    I just read the VIC write up of FCAM. If I drop the post-spin ACAS multiple to 6x I get $17.20 in total value. That’s still +20% upside.

     

     


    SubjectRe: New ACAS
    Entry01/25/2015 10:19 AM
    Memberrsm

    juice - 

    AGNC pays fees of ~$120MM p.a. and 2013 fee rev. at ACAM (the current asset manager) was $213MM so AGNC is 55% of current fees. This proportion should fall further post-spin.

     

    I haven’t discussed comp. with management but I do agree that comp is likely to be high.


    SubjectRe: Re: Still long?
    Entry11/16/2015 08:59 AM
    Membershteinb

    What do people make of the Elliott filing today? Better governance and even more buybacks would be good.. but not sure I agree with not spinning the asset manager. 


    SubjectRe: Re: Re: Still long?
    Entry11/16/2015 01:37 PM
    Memberrsm

    Anything that can put some pressure on ACAS management is good.

    The presentation is a little short on details, not spinning out the asset manager potentially creates some issues around using the DTA’s that would need to be resolved. I will take a look in more detail when I get a chance.

     


    SubjectRe: Re: Re: Re: Still long?
    Entry11/16/2015 08:10 PM
    MemberDaytonCapital

    The only strategic alternative left on the table is a sale. Upside is an outright sale. Downside is a spin. Both scenarios include large buyback. Only uncertainty is timing of NAV discount compression. 


    SubjectRe: Re: Re: Re: Re: Re: Still long?
    Entry11/18/2015 06:02 PM
    Membershteinb

    I am not so sure about Elliott getting support. I've spoken to a number of investors that continue to think the spin is the best option (i tend to agree). I think the dissapointing share price performance the past few days is in part because people think this filing will just cause delays without much gain.  

    If Elliott can bring comp at the asset manager down and boost the buyback prior to the spin, all the better. The tendering for mgmt options / new equity plan are separate items on the ACAS proxy from the spin decision, so there is technically nothing preventing a vote for the spin, and a vote against the comp items. 

    My own view is the asset manager will have a full free float post-spin, so if management misbehaves it should be easy enough for an activist to bring them inline, or force a sale to a more "reputable" asset manager.


    SubjectRe: Re: Re: Re: Re: Re: Re: Still long?
    Entry11/18/2015 06:32 PM
    Memberblaueskobalt

    Why do you think the manager spin is the best route (especially in light of the recent FSC/FSAM developments)?


    SubjectRe: Re: Re: Re: Re: Re: Re: Re: Still long?
    Entry11/18/2015 10:15 PM
    Membershteinb

    I am not sure FSC/FSAM is the best comparable. FSC has had uniquely poor performance, an abnormal fee structure and FSAM is a one-shot business, there's nothing else there. ACAM would be more akin to Ares Management - with a mixture of CLOs, two BDCs (the one that already exists has the best fee structure in the sector), two REITs (both very well regardeded in the market) and a series of private debt and private equity funds. We are talking about something an order of magnitude larger in size, and diversity. Not to mention that ACAM would have proper governance (not majority held by management). Even if it lost its contract to American Capital Income - it would still be a sizable interesting business.  

    Look - would it be nice if say an Oaktree or a PIMCO, or some other "blue-chip" manager came in and bought ACAM without adverse tax consequences, sure. Its just not clear that this is in the cards.

    A split structure with ACAM as a standalone manager that has proper governance , and a BDC with a competetive fee structure makes much more sense than keeping the current mess, which has no natural ownership base. 

    I think best thing Elliott can do is get them to inflate the buy-back via a formal tender. They can sell a bunch of the liquid loan book and tender for a meaningful part of the company.

    David101 - sounds like you have a good sense for management is thinking? Can you talk further...

     

     


    SubjectRe: Re: Re: Re: Re: Still long?
    Entry11/18/2015 10:34 PM
    Memberrsm

    lvampa - there shouldn't be any issues with the DTA.


    SubjectRe: Re: Re: Re: Re: Re: Still long?
    Entry11/19/2015 08:09 AM
    MemberMSLM28

    shteib - surprised to hear that many firms would be OK with SpinCo BDC.  WIth a 7% to 8% initial dividend ACAP will continue to trade like garbage

     

    Re FSC/FSAM: One note is that ACAS mgmt has referenced Northstar as a company with interesting tax & operational structures 

     

    All: we will ask these questions and revert.  Can't imagine Malon gives up much but we'll press a bit


    SubjectRe: Re: Re: Re: Re: Re: Re: Still long?
    Entry11/19/2015 09:24 AM
    Membershteinb

    I think the thinking is, yes potentially the spun BDC will trade say 75-80c on the dollar initially, but it shouldnt take too long to re-deploy the capital into more normal yielding paper. The more stock you buy back now/ the more loans you sell now, the better the yield on the spin co.

    Don't get me wrong - I support Elliott's idea of selling the senior loans and buying back as much stock as practical in a tender. I just dont see why you wouldn't spin the asset manager in the end. Wouldn't surprise me if the final outcome here is a much bigger buyback via formal tender + a spin after the fact. 


    SubjectMgmt Meeting Notes (no comments by us)
    Entry11/19/2015 04:04 PM
    MemberMSLM28

    Here are my notes form the mgmt meeting.  I don’t yet have commentary as I’m still processing the information:

     

    1.      Does the spinoff create more value than Elliott’s plan?

    · Elliot is saying “buyback stock” but ACAS has been doing just that

    · Guided to $300 million to $600 million and guided to tope end of range on Q3 call

    ·  The spin was first contemplated by ACAS’ BoD when Northstar went public

    ·  Since then REITs, BDCs, and asset mgr firms have come down in multiple considerably.  This will be factored into ACAS’ decision to ultimately spin or not

    · “there are multiple ways to unlock value” as “ACAS is a min-conglomerate”

     

    2.      Steps going forward are as follows:

    (1)  complete the process with the SEC to see if they (ACAS) are even legally allowed to spin a RIC BDC

    (2)  Continue to buy back stock in interim.  Goldman has been retained to assist in share buyback

    (3)  Exit the one-stop buyout business.  One stop buyout assets on their books take significant operational, front office, legal, and finance/accounting effort with associated cost.  Costs reduce as assets decline from $1.2 billion year 1 to $400 million year 2 and $0 year 3.

    (4)  When/if ACAS receives approval from SEC they will re-evaluate the spin to see if it still makes sense.

    (5)  If the spin does still make sense they will put it to a vote.  60 days for the vote and then execute the spin a the next quarter end (prob 6/30/16 or 9/30/16)

    (6)  There is definitely a possibility for an additional share tender after the $600 million publically disclosed is exhausted

     

    3.      Where do you think ACAP will trade if spun?

    · “In line with the average BDC which is ~85 cents on the dollar”

    · The 7% dividend per year should rise to ~8% and we think BDC yields broadly will come down.

    ·   BDCs are also trading down due to the Fed’s lack of rate raising

     

    4.  Do you have comments on Elliott’s assertions that ineffective corporate governance and management contracts do not allow outsiders to realistically purchase business?

    · Malon believes Elliott to be mistaken in their assertion.  Further Elliott did not speak to ACAS mgmt before filing their 13D and plan

    · There are key man provisions on many of the private funds but those relate to the PMs/PM teams themselves not Malon

    · The REITs have 1 year contracts that have been long since established

    · Malon does not recall a change of control and thinks “no one would buy an asset manager without negotiating contracts with the management teams anyways”

    · “There is no staggered board at ACAS”

    · “We trade in the market every day.  No reason someone could not buy us”

     

    5.      If ACAS does not pursue the spin-off, what other options are there?

    ·  Could think about selling the manager portion of the business

    ·  “Tiny amount of evidence that internally managed BDCs outperform externally managed BDCs – could revert to RIC status all together.”  This would be done to monetize the management agreement.

    ·  BoD would not sell for less than book value

    ·  If after ample time (not there yet) has passed for people to assess the pro forma BDC spin, if ACAS common is still trading like garbage they would consider buying back “a lot more” stock.

     

    6.   Based on your conversations with investors, do you think you have the votes for SpinCo?

    · Mgmt has no way of knowing this now.  Only 2 weeks since projections were filed

     

     

    My meeting was joint and there were a number of “understand the PF biz questions" by the other investor in the room.  I’ve omitted those here for length considerations


    SubjectRe: New BoD Member - ex #2 shareholder
    Entry11/19/2015 07:27 PM
    MemberDaytonCapital

    Yeah, definitely weird. I assume he isn't "team Elliot," right?


    SubjectStrategic review announced - clearing price
    Entry11/27/2015 08:32 AM
    MemberDaytonCapital

    with buyback and spin already in the cards it seems like the outright sale of ACAS is the last remaining strategic option? 

    Assuming you believe the value of ACAM, anyone think ACAS can fetch NAV or more in a sale? 


    SubjectRe: Strategic review announced - clearing price
    Entry11/27/2015 09:00 AM
    Membershteinb

    I think NAV would be hard, but not hard imaginging getting close to it. Take a look at it from Ares' perspective. If their BDC can buy the assets at say 90% of NAV, with stock, its highly accretive, and will bring substantial scale benefits to their business. This is simlar to what TCP tried to do with TICC. Ares' public asset manager can buy the asset management business. Lots of obvious overlap there.

    Outside of Ares - there are plenty of guys that would love to have a multi-billion dollar permanent capital vehicle (e.g. Fortress, Oaktree, etc.) - that would at the very least have a bid for the asset management business. 

    Do make sure to account for options dilution when you think about NAV. The headline NAV doesnt account for it. Depending on the transaction, not 100% clear to me if the DTA can be saved or not. 


    SubjectRe: Report Hitting the Stock Today
    Entry12/09/2015 06:22 PM
    Membershteinb

    I think a lot of it doesnt make sense. At a high level, they nitpicked two positions which I'll discuss below; but on the whole ACAS have turned over almost their entire portfolio over the last two years in the shift from PE to liquid loans. You can't do that while growing NAV if your marks are fake. On the two names they discuss: 

    1) On Service Experts - the entire argument is dependent on their margin assumption. If you take the 1% margin assumption to 2%, then the entire complaint doesnt make sense. Across the portfolio this is one of the few names with real mark-ups, they've been aggressive marking down names that havent worked (e.g. CML, also a top 10 position). 

    2) On Bellotto Holdings / Hillary's Blinds. There was actually substantial growth in opreating profit from 2013-2014. Also - there was a full refinancing of the company on the back of those results. GE, Ares, Permia all participated (and Permira sold their own equity in the process). Seems reasonable that the company was marked up alongside all that, as well as expanding multiples in Europe. 

    3) They dont mention Delsey - but thats a top 10 position that was sold post quarter end (as was Dyno Holdings). Historically these sales have been right around the mark. 

    4) We can debate the value of ACAM - but the idea that something managing 16bn in permanent capital vehicles is worth 400mm just doesnt make sense. 

    5) Their NAV calculation..they take a 50% haircut to all level 3 assets. BUT - that includes CLOs/RMBS (marks are fairly transparent and dealer based), and mezzanine debt. You can haircut all of these for conservatism, but 50% is silly on a portfolio of largely newly originated mezz and dealer marked CLOs. If you backout ACAM, preferred/common stock Level 3 assets make up just around 1bn of NAV. Even if you do haircut that portion 50%, thats just a 10% impact on NAV. 

    6) They complain that some names are overmarked, and then complain that names are undermarked in the ACE III sale. I've spoken to groups involved and the ACE III process was bid by a variety of dedicated secondary investors that went through these companies - and ACAS took the best bid they got. The idea that they systematically undermarked these names for years in advance of this transaction and then undermined the process is silly. The company sale that took place shortly after ACE III closed was discussed on a conference call... it was a function of the ACE III pool selection and associtaed negotations beggining far earlier. 

    Again - the amount of turnover in positions over the past two years has been so high, mathematically its hard to get to an assumption that the equity positions are overmarked. 

    7) Also in a NAV calc they apply a 5% discount to level 2 assets. These are just liquid loans - i am not sure why you haircut them this way. Loan market is off about 2 pts from Sep 30.

    8) Another 5% discount is then applied to the NAV because of "regulatory discount". Again - i am not sure why.

    Finally - I wouldn't necessarily rely on Elliott - but they were explicit about having done their own diligence on the underlying pool. Given the size of the position they have, and resources they applied, i wouldnt discount their view regarding the marks. 


    The whole thing is sloppy - and i think price action today reflected that. Stock came back in the afternoon to be largely in line with the rest of the space. 

    BTW - does anyone know the research group? i havent heard of their name until today.


    SubjectRe: Re: Report Hitting the Stock Today
    Entry12/09/2015 07:20 PM
    MemberMSLM28

    Nice work shteinb.  We agree on most points.  

     

    The fact that ACAS mgmt is self-dealing is not lost on most longs - they choose to focus on portfolio value & buybacks (and now a marquee activist and the fact they are running a strategic alts process)


    SubjectRe: Re: Report Hitting the Stock Today
    Entry12/09/2015 07:46 PM
    Memberblaueskobalt

    I have never heard of them.  Perhaps they were holding the short before Elliott's 13-D, and they were trying to get out?  As you point out, their ACAM analysis is so poor, that it's hard to believe they were being genuine with this piece.

    A couple questions/comments that I would add:

    1) On Bellotto, I see ~10x EV/EBITDA and ~12x EV/cash EBIT on a business showing substantial growth,  low capital requirements, and a very low cash tax rate.  Looks fine to me.

    2) I'm less comfortable with Service Experts--can you explain your approach?  The 3-year, 10x MOI really sticks out to me, and I think you'd need more of a 3-4% margin to justify (which this business did for a couple of years under LII, but the average has been much lower).

    3) FWIW, I viewed this as a value trap before Elliott's involvement.  Under the current cost structure, ACAM is marked too high.  Similarly, I think a wide NAV discount is appropriate given the poor governance.   Now it's easy to see these key issues being corrected.  Honestly, I was surprised to find an opportunity to enter under $17 after the 13-D, given that it clears up the main issues with the stock.


    SubjectRe: Re: Re: Report Hitting the Stock Today
    Entry12/09/2015 11:50 PM
    Membershteinb

    I don't want to focus too much on service experts since the level of information is low and the resulting discussion is just conjecture. Mathematically i was just saying that at a 2% margin, its maked at a 28x PE, which looks high. But if its a 4% margin, its a 14x PE, which is a reasonable number assuming the business is stable. The difference between 2% and 4% margins isnt that large... It looks like they overhauled the business, took out unprofitable locations and juiced margins to reasonable levels. But its all conjecture. We are basing this whole discussion on a VP's linkedin profile... 

    I think its entirely fair to haircut the equity positions in one's NAV analysis. Just important to keep in mind how small they are in the context of the portfolio at this point. 

    Also - one other common sense way to think about Hillary's Blinds / Bellotto. The refinancing done in 2014 was for 113mm GBP (~170mm USD), and funded entirely by third party lenders. In that context, a $160mm equity value in 2015 seems reasonable. To say that the company was worth 80mm at the time of the refinancing just doesnt make sense. 


    SubjectRe: Re: thanks again
    Entry12/10/2015 12:25 PM
    Memberblaueskobalt

    Here's the link: http://geoinvesting.com/texas-regulatory-filings-mystery-compensation-call-question-american-capitals-internal-controls-managements-integrity/

    Not sure I get their point, though.  Aside from the governance issues and the SEHAC MOI red flag (both covered here yesterday), they seem to imply that SEHAC is owned by Lennox instead of ACAS, even though both parties clearly state that it is owned by ACAS...


    SubjectRe: Re: Re: thanks again
    Entry12/10/2015 12:44 PM
    Membershteinb

    something i saw via a broker today on service experts, gathering another client sent to him: 

    http://www.achrnews.com/articles/125119-boxer-drives-service-experts-resurgence

    An article from dec 2013 where ceo talks about increasinng same store sales 7% and already turning a profit by dec 2013 and hoping to grow 10% next year

    You can google search and see at least 4 or 5 organic acquisitions

    The fulton report says they do 325mm of revenue at 82 branches, their website says they have over 100 branches.  You can also gather off linked in they do 400mm plus of revenue

     

     

     


    SubjectRe: Re: Re: Re: thanks again
    Entry12/10/2015 12:46 PM
    Membershteinb

    Also - i am 90% sure that whole 140mm payment is related to their buy out of Gary Kain's ACAM interest. It has nothing to do with service experts...


    Subject"Permanent" capital at risk?
    Entry12/15/2015 01:37 PM
    Memberrasputin998

    Similar to the discussion on FSAM regarding FSC.  Does anyone see risk here in the AGNC and MTGE vehicles being moved to another manager?  Total return has been horrific lately.  AGNC just reported another 2% mom drop in NAV per share.


    SubjectRe: "Permanent" capital at risk?
    Entry12/15/2015 02:38 PM
    Memberblaueskobalt

    Is that due to management or macro?  It has underperformed NLY by a bit on TTM basis, but it has substantially outperformed NLY over the past 5 years...


    SubjectRe: Re: "Permanent" capital at risk?
    Entry12/15/2015 02:58 PM
    Membershteinb

    Its largely macro - widening MBS spreads, and rising repo rates. Gary Kain who runs the vehicles is well regarded in the mortgage space - I haven't heard anyone complain about him. The management fee at 1.25% of equity (no incentive) seems reasonable. They've also been aggressive at buying back stock across all the vehicles. 

    I am less worried about them losing the business as much as this being a difficult environment to manage these entities without them shrinking.


    SubjectRe: Re: "Permanent" capital at risk?
    Entry12/15/2015 02:58 PM
    Memberrasputin998

    Agreed on the long term performance.  It does seem though that with these things trading at such a steep discount to book and the assets being relatively transparent and liquid that another player could come in and offer the obvious solution to scale down the agency operation and buy back stock.  The inherent conflict of interest for the external manager is really highlighted when these guys choose to keep eroding book value per share month after month with this activity when they can grow book value per share with absolute certainty by buying back stock at such a steep discount.


    SubjectRe: Re: Re: Re: Re: Re: Re: Re: Re: Re: Still long?
    Entry01/07/2016 07:30 PM
    Membershteinb

    You are right about Elliott forcing a sale given the announcement this afternoon. I am all for it if they can get it done.  I think Ares, maybe Blackrock are the realistic buyers since they have BDCs that can take the assets, and asset management businesses that can buy the manager. 

    KCAP is not a good comp - its basically just CLO equity directly + liquid leveraged loans financed with CLO structures (no barriers to entry to doing this) + overmarked asset management businesses + stupid fee structures + garbage scale/liquidity. TICC is in the same boat. Both have also overmarked their CLO equity positions in my view. 

    I agree on fee structure - i think whatever they would have come up with in the end would have been lighter on fees (say 1.5 / 17.5 and netting). I think a 10-20% structured products bucket + a directly originated mezz portfolio (not liquid leveraged loans) + a normal fee structure + a large float would trade quite well (85-90 of book in this environment) and generate a 10%+ ROE). There is no reason that a portfolio like that couldnt be achieved in a reasonable frame of time given the scale of shrinkage via the buyback.  

    If they can pull it off - a sale would be great and i am all for it. With the large buyback and a strategic process in place i think there are a bunch of ways to win with limited downside risk from here.

    As an aside, Wilkus is now in his mid 60s, my guess is he wants a good strategic outcome here as much as anyone 

     

     


    SubjectRe: ACAS update
    Entry03/07/2016 06:57 PM
    Membershteinb

    Service Experts (SEHAC holdings) was sold at what appears to be a premium to the current mark... That was the investment the poorly written short piece that came out targeted a few weeks ago. 


    SubjectRe: Re: Re: ACAS update
    Entry03/09/2016 11:57 AM
    Membershteinb

    Unlikely that they own 100% - assume 10-15% for employee ownership/options, and the number is a bit lower, though still meaningful boost to NAV. 

     

    Yuriy


    Subjectincreasing pace of portfolio company sales
    Entry05/20/2016 11:14 PM
    Memberpuppyeh

    zbeex, am sure you have seen the increasing pace of portfolio company sales at ACAS. on the one hand, it is encouraging (and NAV additive) that all the announced transactions are at a premium to marks (some substantial, like eLynx). on the other hand, i guess you could be concerned that ACAS is harvesting the flowers and keeping the weeds.

    if ACAS is ultimately sold as a whole, where do you think it gets done? I was estimating a slight discount to pro-forma book value ($19?) but I am unsure if that is enough of a discount. perhaps it is more likely to be sold off in pieces, what do you think?

    while clearly it has bounced off the lows, I still think it sets up as a pretty interesting risk reward here.


    SubjectRe: ACAS acquired
    Entry05/23/2016 09:11 AM
    Membershteinb

    Think its a fair outcome given its a complete takeout, where the sector is and I assume the loss of the DTA?

    How long do you think this actually takes to close? I heard both 12 months and 6 months on the call. Decent discount to the deal price in pre so far.

     


    SubjectRe: Re: ACAS acquired
    Entry05/23/2016 10:38 AM
    Membershteinb

    I guess this is potentially an annoying arb to put on, as the short in ARCC has a decent amount of negative carry that doesnt flow through on the other side. 


    SubjectRe: Re: Re: ACAS acquired
    Entry05/23/2016 08:58 PM
    Memberpuppyeh

    thanks zbeex, yes this got done finally. as you mentioned, not a horrible outcome at all, the large cash component and sale in one piece a decent offset to what is still lower price than i expected. agree too w shteinb that terrible to put this arb on and thus will trade cheap for a while to implied deal value.

    i guess this is going to be a boring stock for the next six months then...


    SubjectRe: Re: Re: Report Hitting the Stock Today
    Entry08/02/2017 10:06 PM
    Memberblaueskobalt

    FWIW, ARCC announced the sale of ACAS's legacy investment in Bellotto on their CC today.  Proceeds were over 50% higher than the mark that these guys took issue with, 18 months later.

    Worst short report ever?

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