Value Investors Club / american capital (ACAS)

Description

I am recommending a long equity position in American Capital (ACAS) at ~3.00 / share, which presents a compelling risk-reward proposition, with a total return potential of >100% over the next 3 - 6 months (based on probability tree matrix further below). ACAS is (i) unloved (shareholder base temporarily in flux and short interest is still >15% of total outstanding shares creating a real element of surprise); (ii) mis-perceived (i.e. concerns around ongoing credit negotiations - currently in default on about half of its ~3.7Bln PF Sep net debt - is overdone and I believe will be resolved over the next couple weeks that will likely surprise "Mr. Market's" extremely pessimistic view - notable that bonds are trading well bid in the mid-80s vs the lows of 30 - 35 earlier this year w/ one of the tightest yields I've seen for a non-investment grade financial security suggesting the negotiations are coming to a head ... and also highlighting how the credit markets may be anticipating a near-term amendment, but equity has seemingly not reacted so far); (iii) mis-understood (i.e. generic Street view is that ACAS has a disproportionate mix of equity holdings and was overly aggressive on taking control positions at peak multiples - while this view is partially accurate, most of the "negativity" has already been factored into ACAS' current marked-down June 09 book value and more pragmatically, ACAS' underlying portfolio is showing real incremental improvements - more detailed discussion in the biz overview section below - YET Street has very muted future expectations and moreover, Street believes a run-down / liquidation scenario is a high probability scenario which I think is overly-punitive); and (iv) mis-valued (ACAS equity currently trades at around ~0.4x June 09 book value versus BDC comps including AINV, ARCC, PNNT at ~0.9x - note that this "June book value" has effectively marked the cost basis down to around ~59 cents versus initial "cost" which compares to other BDCs that have marks in the 65 - 85 cent range so arguably very punitive ... more notably, ACAS equity correspondingly trades at around 0.15x its "cost basis").

While ACAS pessimists will argue that the business is fundamentally flawed and over-exposed to control positions consummated at peak multiples at the peak of the credit cycle, I'd argue that most of the downside + negative sentiment is largely baked in at current valuations (i.e. book value has already largely taken a fine knife to the "equity-like" securities) and, moreover, I think there a couple mis-perceptions that have created overly-negative sentiment - discussed further below) and there are a couple notable near-term upside surprises (largely given how low the hurdle has been set at this point). Longer-term, I do NOT think the business is broken and ultimately think an equivalent book multiple to its peers can be realized as management regains credibility and confidence (NOTE that this multiple expansion scenario is pure upside and I'm NOT docking on this in my FV of around $6 / share as highlighted in my Base Case below).

One often-overlooked call option to ACAS (which was ultimately the critical angle to the short thesis 12-mths back and largely came to fruition) is that outside of ACAS' core / private finance portfolio - i.e. >$7.9Bln of the $10.3Bln "cost basis" - the business sits on two high-octane (and I'd argue largely "free" given how negative the Street is on both of these items) call options that nobody appears to be is factoring in right now: (i) European finance division (cost basis of ~$1.3Bln and currently marked at ~$97mm - this is a very similar portfolio to ACAS' US corporate finance portfolio and ACAS is currently in negotiations w/ its creditors in a process that is being led by Miller Buckfire ... while I don't yet have an angle on how this process will turn out, my sense is that banks / creditors involved on the European side are more willing to "kick-the-can" down the road especially given the significant improvements in the European credit markets at large - as a result, the European call option could be perceived to be much more in-the-$ over the next couple mths and could be a significant source of upside value over the next couple qtrs if the global economy sees further improvements) and (ii) ACAS' structured products portfolio (cost basis of ~1Bln and currently written down to $174MM) could surprise to the upside given combination of CLO and CMBS holdings that have been quite reactive over the past 3 - 6 mths - while ACAS does not provide a great deal of information on these securities, the market has done a 180-degree about-face on these structured securities with ongoing / improved liquidity - witness Victoria Finance, a SIV that defaulted last year, sold ~$4.3Bln of CDO liabilities on Friday which highlights the increased volumes / price levels and appetite around these types of structured product portfolios.

SUMMARY THESIS:

Overall, I view ACAS equity as a hyper call option on the credit markets (the past 3-mths in particular have seen significant upward moves in the credit markets which includes both large / liquid securities and I'm beginning to see real appetite for smaller / less-liquid securities) with multiple n-term catalysts (its worth noting that the BDC universe typically lags the more liquid / public universe by 3 - 6 months given the mix of Level 1 - 3 assets (but ultimately, given the tag lag, the September 2009 and December 2009 book value / marks should show incremental improvements versus the June 2009 low). While there are n-term concerns and confusion around ACAS' ongoing credit negotiations (currently in default on approximately $2.25Bln of private / public bonds as well as its unsecured revolver), I think Mr. Market's sentiment / perception hurdle is very low at this stage and any compromise (I'm assuming a coupon bump up to 9 - 10%, additional security package and a more amendable amortization schedule) would be a significant positive surprise to equity holders (especially considering how negative the Street is at this stage). What gives me more confidence around the (i) ongoing credit negotiations and (ii) n-term portfolio out-performance is both the recent traction mgmt has shown in paying down debt (two transactions announced in mid-Sep will likely result in >225MM of debt paydown and >35MM of gains vs the June 09 mark). As a result, it's worth noting that the PF net debt balance as of September 2009 will likely be below $3.7Bln given cash balance improvements and recent asset sales (based on Q2 09 conference call disclosures and recent press releases).

More notably, there are ~13 - 15 core (i.e. >40MM in size) positions w/in ACAS' portfolio (note the total portfolio is >270 companies so very widely diversified) that I believe are high quality, liquid (i.e. saleable over the next 3 - 6 months) and should yield an incremental gain from the June 09 mark (note these 15 positions comprise ~$2.5Bln of ACAS' "Cost" portfolio or ~25% of "Cost"). My sense is that management has educated its creditors on the inherent value of these core positions and that creditors are more amendable; in addition, my sense is that ACAS' NAV will show incremental improvements over the next 2 - 3 qtrs and NAV will likely finish the year at / above $10 - $12 / share (vs ~$7.42 / share currently) which implies an additional $700 - $1,250MM of equity value (driven by portfolio performance - upside potential to this estimate could come via European Capital renegotiations and possibly further liquidity / improvements in the structured product portfolio).

As referenced above and noted in more detail further below, viewing the portfolio from the bottom-up (80 / 20 rule), there are ~15 larger / liquid positions that I've done a decent amount of work on that comprise ~$2.5Bln of ACAS' ~$10.3Bln "Cost" portfolio (that I believe will result in gains from the June 2009 mark) that will provide greater confidence in the collateral. Taking this logic one step further, its worth noting that PF for selling these 15 companies (noted above - a definite possibility over the next 3 - 6 months given how much information is readily available in these securities in particular), the PF net debt balance would be in the $1.25 - $1.5Bln range (this implies ACAS receives its full "cost basis" on these 15 companies which is a low probability BUT I'm noting it for optics sake given my views on the quality of these assets). More notably, on the $1.25 - $1.5Bln of PF net debt (post the hypothetical sale of these securities), there would be approximately ~$7.5Bln of "cost" / value retailed in the ongoing portfolio (albeit - these would be more private / "mark-to-model" positions which is very similar to AINV / ARCC / PNNT portfolios). Said a different way, for the equity to NOT be have any value, the recovery value on the hypothetical PF portfolio would have to be less than 18 cents on the $ ($1.33 mid-pt / $7.5Bln = ~18 cents). Said a different way, for the equity to be worth $6 / share (Base Case), the recovery value on the remaining $7.5Bln of securities would have to be 40 cents on the $ (i.e. $1.7Bln of equity value / 285MM shares + $1.33Bln of net debt = ~$3Bln / $7.5 = 40 cents). The pts above are simply being used there to highlight the possibility (which I think is exponentially increasing) of a virtuous cycle in ACAS (following what was arguably one of the worse / vicious cycles they went through over the past 6 - 12 months).

While I don't think ACAS deserves an equivalent multiple to its closest peers (~0.9x), the margin of safety is in applying ACAS' current Mr. Market multiple (0.4 - 0.6x) to its PF book value (which argues for a FV of around $5 - $7 / share or >100% above current price). The upside case will be driven by potential multiple expansion to a level that mirrors BDC peers; if perception changes around ACAS and the market focuses more on the upside optionality of ACAS' book (i.e. most other BDCs do NOT have real embedded optionality from structured products nor European portfolio holdings - i.e. takes an asset focus vs liability focus as it did over the past 6 - 12 mths) and applies an equiv multiple of 0.9x to PF book value (or $10 / share or >200 - 300% upside) over the next 3 - 6 mths.

ACAS MIS-PERCEPTIONS:

While the BDC industry (ALD in particular) has received a fair amount of flack, three mis-perceptions have created significant margin-of-safety around ACAS and ultimately the hyper call option around fundamental operating performance that will likely be "less-bad-than-feared":

Mis-Perception #1 - credit negotiation uncertainty: my sense is that this will come to a head in the very n-term and will be viewed favorably as it will take off the table the solvency risk / liquidation concern - note that most of the Street uses a liquidation analysis to drive their price targets ... I believe this cloud of confusion once removed should result in a re-valuation as the perception around the biz (longer-term liabilities better matched w/ longer- assets) will improve. On this first point, its worth noting that the public bonds ($548MM in size are well bid in the mid-80s - tightest yield for a non-IG rated financial security which perhaps reflects credit leading equity in information and the belief that things are "less-worse-than-feared" and that there might be a positive compromise out in the n-term)

Mis-Perception #2 - belief that ALD negotiation will be used as template for ACAS: the markets are generally looking at the recent ALD credit re-negotiation and using this as a possible template - BUT I think there is a high probability that the amendment will be less onerous for ACAS for the following reasons: (i) ACAS mgmt is arguably higher quality and portrays themselves in a position of relative strength vs ALD mgmt, (ii) ACAS is negotiating w/ three parties (banks, private institutions / largely insurance cos and public / largely hedge funds) as compared to ALD w/ 2 constituents which favors ACAS given a more fragmented lender base and more lopsided to "relationship" banks and institutions, (iii) recent ACAS events (sold two portfolio cos for >225MM for a >35MM gain as compared to the June 09 mark) will likely generate more goodwill and (iv) as the credit markets have shown further improvements, timing should be an incremental benefit to ACAS (esp as we consider lenders are probably more willing now to kick-the-can-down-the-road given how common this "kick-the-can" approach has been over the past 3 mths in particular)

Mis-Perception #3 - ACAS portfolio is more toxic than BDC peers: while there is a common belief around ACAS (some of which I'd fully admit was true 6 - 12 mths ago when the marks were closer to "cost") that they took greater risk via control positions at the peak of the market, I'd argue that (i) the ACAS portfolio has been written down much more aggressively than its peers (currently at around 59 cents of original cost as of June book value calc which compares to 65 - 85 on its closest peers) and (ii) given the more conservative marks, the ACAS portfolio has significantly more upside optionality over the next 3 - 9 mths (while the portfolio mix explains some of the disparity, I'd argue they have taken relatively conservative marks as of June 2009 on the whole). More pragmatically, I've done a more thorough analysis on 15 of ACAS' larger (defined as >40MM) and liquid holdings and the conclusion is that there will very likely be a 5 - 10% increase in its NAV for the Sep 09 (compared to June) qtr which should result in >$1.50 - $3.00 / share of NAV improvement (based on approximately 285MM shares).

SUMMARY CAP TABLE (JUNE 2009):

It's worth pointing out just how vicious the credit cycle has been on ACAS (probably easiest to tell the 1^st part of the story through the NAV / share moves). At YE 2007, the PF BV / share was around $26 / share. At the end of 2008, it finished the year at around $12.50 / share. As of June 2009, the BV / share currently sits at around $7.42 / share (or approximately 29% of peak). Interestingly (and noted above), June 2009's BV is marked at around 59 cents (vs a total implied "Cost" of ~$10.3Bln). Mr. Market is currently valuing the shares in the low $3 / share range which implies 0.15x of "Cost" basis.

The Cap table below effectively highlights four classes of debt securities: (i) ~$2.0Bln of securitizations (NOT in default and NOT in negotiations) - non-recourse and are over-collateralized at a ratio of around 1.27x, so the $2Bln of securitizations have a claim on around $2.5Bln of their investment book roughly split 50/50 against the senior/senior sub notes, (ii) ~$1.4Bln revolver (held by large relationship institutions), (iii) $548MM of public notes (mostly held by special situations hedge funds as well as insurance cos), (iv) $311MM of private notes (mostly held by insurance cos). Two notable recent updates from the company: (i) cash balance as of the Q2 call in early August was around $300MM (up from $180 - $190MM as of June 09) and (ii) 2 recent portfolio sales (totaling around $220 - $250MM) were completed in September with the likely use of proceeds to be used for debt pay-down. Given these two updates, its worth noting that the PF September 2009 NET debt balance is now around $3.7Bln. While there is still a significant amount of wood to chop, my only point is that goodwill is likely being built by management and perception around the business making it through the cycle has arguably been incrementally improved.

Securitizations             1,992

Private Notes              311
Public Notes                548
Unsecured Revolver    1,388

Total General Unsecured Debt = $2,247 X 85 cents at market = $1.9Bln

Shares Out 284

Share Price $3.20 / share

Market Cap $906

Cash(1) 530

TEV 4,615

(1) Q2 call and asset sales

SUMMARY BIZ OVERVIEW:

The graph below summarizes ACAS' business mix. As highlighted, based on the June 2009 mark, >35% of ACAS book is comprised of senior debt, ~35% subordinated debt and ~30% "equity-like" securities. As compared to ALD, ACAS has a more attractive / balanced mix of senior loans and subordinated notes (ALD is much more heavily weighted to the junior securities).

	Original	Jun-09	Effective	% of
	Cost	FV	Mark	Portfolio (2)
Snr Debt	$3,394	$2,150	63.3%	35.3%
Subordinated Debt	$2,816	$2,138	75.9%	35.1%
"Equity-Like" Securities(1)	$4,085	$1,810	44.3%	29.7%
TOTAL	$10,295	$6,098	59.2%	100.0%
(1) Includes preferreds, warrants and common equity in affiliate and non-affiliate portfolio cos
(2) Based on current June 2009 mark

There are effectively three levers of value to the ACAS portfolio (note that Levers 2 and 3 have effectively been written down to arguably "free call option" levels BUT that I think have real potential for n-term upside (note that this upside potential is margin-of-safety to the trade and will be pure upside if we're surprised).

Lever 1 - Core / private portfolio: comprises >200 portfolio companies w/ an average investment size of ~$40MM. Below, I've provided a summary snapshot of ~15 portfolio companies that are liquid (in many cases quoted / on-the-run) and I believe have significant near-term upside potential (versus June 2009 mark) if sold. Note that most of the remaining positions w/in ACAS portfolio (i.e. those that are not quoted) are marked-to-model. While the Street (during times of skepticism) likes to throw mud at this mark-to-model approach given the negative Level 3 taint, my view is that's its an equivalent valuation approach to the other BDCs performed quarterly (using a consistent approach) and affirmed by a 3rd party (the valuation exercise typically takes into consideration underlying portfolio performance, notable changes in mgmt outlook as well as comparable company trading levels and discount rates - overall, I agree w/ ACAS mgmt's assessment on their Q2 call which noted they lag both downturns and recoveries BUT ultimately see the flow-through on a 3 - 6 mth trailing basis - which suggests the flow-through will be seen in Q3 and Q4 marks)

We've gone through 15 of ACAS' larger positions (as well as handful that are more "on-the-run") and the takeaway is that there is that (i) the ACAS portfolio is NOT in dire straits, (ii) there is >$2Bln of realizable value over the next 3 - 6 months and (iii) there is real upside potential from these more liquid / on-the-run names in particular. While I think these securities could be sold over the next 3 - 6 months, the ultimate pt is that the underlying collateral in the "quotable" portion of their portion is on pretty solid footing. Factoring in the remaining >200 portfolio companies / structured products, etc that comprise the remaining ~7.8Bln of ACAS' "Cost", the hurdle rate is effectively a ~20 cent recovery (anything above that amt equates to equity upside). As detailed further below, my view is that a 40 - 60 cent recovery (even in a liquidation scenario) is feasible and there would likely be strategic interest in portions (or all) of their portfolio from other BDCs / financial institutions (or $1.5Bln - $3Bln of value to the equity or $5.25 - $10.50 / share of value). However, the biggest risk in a liquidation scenario is the time leakage (as it could take 1 - 3 years to fully liquidate the portfolio)

Category #1: Debt (mostly snr) that's liquid / sellable and would yield a gain from June 09 mark

Orchard Brands ($366.1MM carried at $243.2MM) >> quoted at ~70 so ~30 - 35MM of upside
Ranpak snr debt ($139.3MM carried at $99.2MM) >> quoted in the low 90s so ~30 - 40MM of upside
Ford Motor Cos revolver ($107MM carried at $80MM on books) >> quoted in low 90s so ~17MM upside
Inovis ($88MM carried at $82.6MM) >> solid biz and sellable
National Processing Co ($52.8MM carried at $32.9MM) >> quoted at 79 so ~9MM upside
TransFirst ($49.6MM carried at $30.3MM) >> quoted at 78 so ~8MM upside
French Lick Snr Debt ($32MM carried at $18.3) >>quoted 65 - 70 so $2 - 3MM upside
KIK 2nds ($21.5MM carried at $3.6MM) >> quoted >50 so ~$7.5 - 10MM upside
Jacobson 1sts ($19MM carried at $11.7MM) >> quoted 85 - 90 so $4 - $6MM upside

TOTAL Category #1 (9 positions) = $850MM of Cost w/ >$125MM of embedded upside in n-term

Category #2: Control Positions in which I know / like the biz and believe there could be a liquid / n-term sale at a premium

American General Agency (AGNC - publicly traded) - ACAS owns approx 5MM of 18.8MM total shares out ($150MM of value - up $40MM since June)
Mirion Technologies (MION) S-1 filing is pending IPO listing >> solid biz >> $314MM of value on books (of which >$145MM in "equity")
Rug Doctor (RDR Holdings) >> very solid / stable biz >> $385MM invested
WIS Holdings >> solid biz >> $236MM of value (of which >130MM in equity like securities)
Stadium Mgmt Group (SMG) >> good biz >> $228MM of value
TestAmerica >> decent biz >> over $250MM invested

TOTAL Category #2 (6 positions) = around $1.6Bln of "Cost" w/ ability to either sell / re-capitalize or exit the respective position (w/ decent upside risk to meeting / exceeding current June 09 mark)

Levers 2 & 3 - European Capital and Structured Products: as noted above, these two levers can be viewed as pure option value and are margin-of-safety to the trade (key n-term events will be around credit re-negotiation as well as underlying US private portfolio performance). In total, the cost basis of these two levers is >$2.2Bln as is currently being marked on the ACAS book at around $271MM (or approximately 12% of cost). As noted further above, European Capital is currently going through a restructuring process and concurrently, ACAS is seeking out strategic alternatives as well with Citigroup - note that while the European vehicle also has a fair mix of "mark-to-model" small portfolio companies, the European credit markets have also rebounded quite handsomely (even more so than the US I'd argue) and there may be upside opportunities in the n-term. Re: the structured product portfolio, this is mostly comprised of CLO and CMBS securities (while the 10q and 10k provides summary information, details are a bit lacking which makes it hard to value the 5 - 7 largest securities that drive the portfolio). However, while the information is sparse, it's safe to say that there might be a $150 - $300MM mark-up in this portfolio given some of the recent / significant moves in the CLO and CMBS markets (more liquidity).

UPSIDE / DOWNSIDE:

UPSIDE (35% probability): assumes the credit negotiations successfully come to a conclusion over the next 1 - 2 months. Applying a 0.8 - 1x multiple to PF book value (equivalent multiple to its closest peers), equates to a $10 - $12 / share FV (or approx 200% - 300% upside versus current $3 / share price). This scenario assumes I'm directionally correct that the next 3 - 6 mths will see a $2.50 - $4.50 / share expansion in NAV from the current ~$7.50 / share mark as of June 2009

BASE (60% probability): assumes the credit negotiations successfully come to a conclusion over the next 1 - 2 months. Assuming the naysayers are right (i.e. ACAS deserves a discounted multiple to peers that trade at around 0.9x - 1.0x book value), and applying a consistent current "Mr. Market" multiple at around 0.4x - 0.5x to PF book value, this equates to $5 - $7 / share of FV (or approx 65% - 135% upside). Base Case assumes NO multiple expansion which I think is very unlikely (witness PNNT / AINV / ARCC - as perception changes, multiples for each of these BDCs has expanded to ~1.0x book value). This scenario assumes I'm directionally correct that the next 3 - 6 mths will see a $2.50 - $4.50 / share expansion in NAV from the current ~$7.50 / share mark as of June 2009

DOWNSIDE (5% probability): assumes the credit negotiations fail (I view this as less than a 2.5% probability but for conservatism, I've assumed 5% in the matrix tree) and the company is forced to go through an orderly liquidation. Given my views that there is >2Bln of "markable / quotable / sellable" securities, I believe the debt load can effectively be reduced to around 1.5Bln within the next 3 - 6 months (offsetting PF cost basis of the portfolio at that stage is around ~7.5Bln post these asset sales). At which pt, the bet is a 1 - 3 year orderly liquidation bet. The equity hurdle to be in-the-$ is effectively 20 cents ($1.5 / 7.5Bln). My belief is that IF the liquidation scenario were to occur, you would see a handful of larger / strategic bids for the entire (or portions) of the biz (perhaps from BDC peers or financial institutions looking to expand into middle-market lending). My liquidation scenario assumes 40 - 60 cent recovery on the remaining $7.5Bln which implies $3 - $4.5Bln recovery (equity receives everything above the PF debt balance of $1.5Bln). The biggest risk w/ the downside scenario is timing. Assuming the process takes 1 - 3 years and applying a 20% discount rate, the recovery falls to approximately $2.2 - $3.2Bln which implies an equity value of around $2.50 - $6.00 / share (decent margin-of-safety given current share price at ~$3 / share). We can debate the merits of this Downside Case further but I think the critical difference to my view as compared to the Street's is that there is significant value that can be realized in the first 1 - 3 months (given 15 portfolio companies are quotable / liquid / saleable which drives between $2 - $2.5Bln of value). Given how the private bonds have traded (mid-80s currently), I'd argue that creditors are getting much more comfortable w/ the underlying collateral and mimic the view above

CATALYSTS:

N-Term Completion of Credit Negotiations (2 - 6 weeks): my sense is that it's closer to completion and should be on more favorable terms than ALD

N-term Portfolio Out-Performance (4 - 6 weeks): the Sep 2009 mark on portfolio will likely be significantly higher than "Mr. Market" fears / Street expectations (reports Nov 10th)

N-Term Positive Technicals (4 - 6 weeks): Consensus is that's its pretty much hated and heavily shorted; Still very much an orphan BDC at this pt

N-Term Asset Sales (2 - 6 months): could incrementally shift perception to the upside (as noted in the write-up above, there are ~$2.5Bln of securities that I believe are liquid / saleable over the next 3 - 12 months at a premium valuation to the June 2009 mark) as ACAS continues to pay down debt and take gains on the sales (versus June 09 mark / muted expectations)

M-Term Hyper Call Option (3 - 6 months): Leveraged caboose trade to credit continuing to rally (typically lags credit down and up moves by 3 - 6 months)

L-Term Embedded Margin-of-Safety: Mr. Market mark significant disct to Cost (~0.4x) and current "Mr. Mkt" value significant disct to "Cost" basis mark (~0.15x)

- Currently trading at ~0.4x book (of which book value has been marked down to ~59 cents)

L-Term Possibility of Regaining Confidence (3 - 12 months): Mgmt purchases more equity post any creditor re-negotiation in sign of support (and helps in re-gaining credibility / confidence ... right now, Street is acting like the equity is perhaps NOT the fulcrum security ... any incremental confidence around the equity being in the money, would create significant upside optionality)

RISKS:

N-term risk: Perception becomes reality in financials - I'll admit that perception / confidence have a significant impact on BDCs and financial institutions so should not be taken lightly. As of right now, however, I think ACAS' position is NOT un-tenable and believe a comprise will be met re: the ongoing negotiations w/ creditors

N-term risk: Negotiations turn more aggressive / expensive (low likelihood in my view given the fact-pattern so far)

M-term risk: FCF of biz is inadequate to support (low likelihood as I think asset sales will provide adequate n-term liquidity to pay-down the debt load and service interest expense)

L-term risk: Orphan retail investor base; how does ACAS mgmt regain credibility? (longer-term concern)

Catalyst