Subs: New Buy $$

• Posted by ToddSullivan
• on December 4th, 2009

This one is a little complex and priced for extinction. When extinction does not come, I think we see dramatic upside.

From the website:
American Capital (Nasdaq:ACAS), with $12 billion in capital resources under management, is a publicly traded private equity firm and global asset manager. American Capital, both directly and through its global asset management business, originates, underwrites and manages investments in middle market private equity, leveraged finance, real estate and structured products. American Capital and its affiliates invest from $5 million to $400 million per company in North America and €5 million to €100 million per company in Europe.

Since its August 1997 IPO, American Capital and the funds it manages have invested approximately $33 billion in 519 portfolio companies. Our diverse portfolio is invested in virtually every industry sector. We have over 120 investment professionals in 8 offices in the United States, Europe and Asia.

So, what is the investing thesis? We have a well run company with a terrific history of returning cash to shareholders ($30 in dividends since 1997). It is currently selling for $2.95 a share with a net asset value of $7.38 a share. Historically the company has traded about par with its NAV.

Why the disconnect? Same story as we have seen countless time the last year, debt issues. But these debt issues are a bit different. Being a holder of assets, ACAS fell under debt covenant violations not due to failure to make interest payments (they currently have 2.2X interest coverage) but because of asset value write downs cause valuation violations. This naturally in the environment we are in cause a panic and then the notorious “going concern” notice.

As addressed in the 10Q:

In our annual report on Form 10-K for the year ended December 31, 2008, our independent registered public
accounting firm, Ernst & Young LLP, concluded that substantial doubt existed about our ability to continue as a going concern as a result of being in breach of certain financial covenants under our unsecured borrowing arrangements. The breach of these financial covenants was primarily due to the significant decrease in our shareholders’ equity as a result of net unrealized depreciation on our portfolio investments during 2008. As of September 30, 2009, we continued to be in breach of these financial covenants on $2.4 billion of unsecured borrowing arrangements.

On August 28, 2009, the holders of our private unsecured notes declared that the unpaid principal amount of the notes outstanding, plus all accrued and unpaid interest and the respective make-whole interest payment for each series, were immediately due and payable. Although we have not repaid these obligations in full, we have entered into forbearance agreements with all of these noteholders, under which the noteholders agreed to forbear from exercising certain rights and remedies with respect to the events of default that have occurred under their respective series. The holders of a majority in principal amount of the notes outstanding under each series may terminate the forbearance agreement for the series at any time. In consideration for entering into the forbearance agreements, we paid all accrued and unpaid interest due on the notes as of September 1, 2009 at the default rate retroactive to March 30, 2009 and agreed to add to the outstanding principal amounts of certain of the notes the respective make-whole interest payment.

The lenders under our unsecured revolving line of credit and the holders of our public unsecured notes may also declare all obligations outstanding under the facility and the notes to be immediately due and payable after any applicable notice periods. If this were to occur, there is no assurance that we will have sufficient funds available to pay in full the total amount of obligations that would become due as a result of such accelerations or that we will be able to obtain additional or alternative financing to pay or refinance any such accelerated obligations.

However, we continue to believe that we will have adequate liquidity to continue to fund our operations and the interest payments on our outstanding debt, including any default interest. We continue to have active discussions with our unsecured lenders and noteholders regarding a restructuring of our debt arrangements. We have retained Miller Buckfire & Co. LLC as a financial advisor to assist us in our efforts to restructure these debt arrangements. We continue to believe that we will successfully renegotiate the unsecured debt arrangements with our lenders and noteholders and that we will continue to exist as a going concern.

That was Oct. 30th. On November 3rd, they announced agreement in principle on $2.4B of unsecured debt.

On Nov. 20th they agreed to a lock up with 95% of the unsecured creditors. They have said they plan to have this resolved before the end of the year. My assumption is when they do, the “going concern” notice is removed and the stock jumps.

Let’s look at the write down and what they mean for the future.

Much of what ACAS invests in is “Level 3″ products. Meaning they are not liquid securities. Because of that, valuation quotes are typically found through 3rd party broker dealers. When we are in a CMBS lockdown like we were the first nine months of the year, those quotes do not reflect the economic true value of the assets but accounting rules say they must be accounted for as through they do.

Here is the total difference between GAAP value and the company’s expected value. (>$1B)

Here is an actual level three example. An asset that produced $5m of cash flow in Q1 was forced to be written down to $12m

Now, with the recent surge in the CMBS market in the last few weeks, we ought to see these prices firming which means they valuation write-downs should reverse into write-ups. We should also see a possible expectation of increase total recovery as the CMBS market is brought back to health.  As asset prices in general firm, the same for the rest of the portfolio would hold.

If we look at their portfolio results it shops the bulk of the writedowns are in the debt. Note: equity reductions are largly due to assets sales, not deterioration of portfolio.

I want everyone to look through the 10Q, specifically pages 8-33. This is the most transparent 10Q I have ever seen. Every investment is broken down both in term of costs and current “fair value”.

Here is the most recent 10Q

I also like the fact management has large personal stakes in the company, to me it implies much like General Growth (GGWPQ), even in a worse case scenario, shareholder interests would be protected. It also means they will attempt to avoid Chapter 11 at all costs.

Investor Fact Sheet

Company Profiled

Morningstar Report (June 2009): Note: there is significant pessimism in the report. Remember the time it was written though, June, things for debt markets and the economy have improved markedly since then. Without this pessimism, we would not be able to get a good price though.

Full portfolio holdings are listed here

I think once debt restructuring is complete, we trade at/near NAV. I also think NAV will rise as debt markets return to better health meaning we have >100% upside from current levels.

RISK: Debt restructuring fails and they are forced into Chapter 11 (then all bets are off). I think this is unlikely BUT it is still a possibility.

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