Thursday, October 8, 2015

American Capital: ACAP Form 10 and Proxy Notes

I was starting to get nervous there that American Capital (ACAS) would miss their own self imposed September deadline to file the Form 10 for their proposed BDC spinoff American Capital Income (ACAP), but on 9/30 ACAS filed a draft proxy statement (along with the Form 10) with several proposals to put to a shareholder vote that will move the long anticipated spinoff forward.

To recap my earlier post, American Capital will be spinning off a BDC that will pay dividends (hopefully attracting retail investors and raising the valuation), leaving ACAS with the management company that will have almost $23B in AUM inclusive of the spinoff (most of which is permanent capital).  The company pegs its current NAV at $20.35 per share, which includes the value of the management company, the stock currently trades for $12.50, a ~40% discount to NAV.

American Capital Income (ACAP)
There's a bifurcation between the valuation of internally managed BDCs and externally managed ones, with internally managed BDCs being valued at slightly over NAV, and externally ones below NAV, in some cases substantially under.  BDCs require shareholder approval to issue shares below NAV, so there's a strong incentive over time for externally managed BDCs to increase their share price through fee reductions, share repurchases or simply better performance.  Below is a table of prominent BDCs (and less prominent ones like ACSF) to give an idea of how they currently trade.
The BDC spinoff, American Capital Income (ACAP), will be one of the largest BDCs and has a close peer in Ares Capital Corp (ARCC).  Both implement a similar strategy, are roughly the same size, externally managed, and the external managers are publicly traded.  But besides a more stable history, ACAP has a few hurdles to overcome before it can trade inline with ARCC's 92% of NAV.
  1. ACAS, the asset manager, is going to charge ACAP a 1.75% base management fee on assets (not equity and including cash) plus incentive fees which will charge ACAP an additional 20% of gains as long as they hit the 8% hurdle rate.  The base management fee is 25 bps more than Ares Management charges Ares Capital, but the incentive fee has a slightly higher hurdle rate (7% versus 8%), in most circumstances ACAP will be paying 0.35-0.50% more in fees for comparable performance as ARCC (remember, it's an extra 0.25% on assets not equity).  While it's good for ACAS, hopefully they reconsider and move the base management fee down to 1.5%, management will be disproportionately invested in ACAS going forward but much of the value creation from the spinoff is coming from ACAP moving closer to NAV.
  2. The ACAP portfolio is going to initially be a little funky with about $1B in equity/control investments that were previously sourced by American Capital's "One Stop Buyout" program, which they've shuttered.  Since they won't be able to raise equity for a while the equity investments can be a source of funds, the plan is likely to exit these over time and reinvest in middle market and syndicated bank loans creating a more diversified, simpler to value portfolio.
  3. ACAP's proforma leverage is around 140%, well below peers, which along with the equity slug and relatively overweight senior bank loans (where they're parking the leverage) means it's going to under earn initially until they get their portfolio ramped up and more inline with peers.
Even given these challenges, ACAP should at least trade for 80% of NAV, or $3.3B, inline with its sister BDC in ACSF (which is a dedicated bank loan BDC) within a quarter or two of reinstating the dividend and overtime close the gap with it's closest peer ARCC.

New American Capital (ACAS)
ACAS will be primarily an asset manager with some assets set aside to seed new strategies/funds before they eventually get sold into those vehicles.  Including the new BDC, ACAS will manage 4 publicly traded companies, two BDCs in ACAP and ACSF, and two mortgage REITs in AGNC and MTGE, along with 14 private funds (private equity and CLOs primarily) totaling $22.75B in fee earning AUM (in some of their strategies they only get paid on the equity, not the assets).
82% of American Capital's assets will be in permanent capital vehicles which should garner a premium over time.  I have a hard time determining if they're good investors, but it's fairly clear they're good asset gathers.  Interest rates are likely to stay low for some time, forcing investors to chase yield, and most of American Capital's strategies cater to those yield chasers.  ACAS puts a value on the asset manager each quarter, the latest was $1.1B, I tried unpacking that in my earlier post in February so I won't rehash that now.  They're also going to include roughly $1B in investments on the balance sheet of the manager.  My guess is the asset manager is going to be the preferred security of the two and should be valued at close to $2.1B.

Using the fully diluted share count of 283 million shares = $11.53 (ACAP) + $7.41 (ACAS) = $18.95 per share, or 50% upside from current ~$12.50 prices.

Incentive Plan & Option Tender Proposals
One of the primary knocks on ACAS is they pay themselves handsomely, siphoning off value from shareholders and re-directing it to insiders and management via stock options.  Many of their options were issued deep in the crisis, and don't expire for 10 years, just look at the CEO's:
Even at today's depressed prices these options have a current value of $24MM, and they've created an overhang on the share price.  Adding to the dilution pain, because of the spinoff, employee options holders are forced to exercise their options (issuing shares below NAV) prior to the spinoff:
"... we are prohibited under the 1940 Act from issuing options in ACAP stock to American Capital employees."  
"... because option holders are not able to participate in the spin-off and option holders have thus had to exercise vested options earlier than necessary and at lower than optimal prices, the options previously granted under our existing plans have lost significant retention value."
In their second quarter investor presentation they laid out the impact of employees exercising their stock options earlier:
This dynamic has created some forced sellers in the market, presumably ACAS employees don't want to exercise their options ahead of the value unlocking spinoff, but they have to, potentially putting unwarranted downward pressure on shares recently.  On August 5, the company announced they would buyback $300-600MM worth of shares, in part to counterbalance the options being exercised and as of the end of the third quarter they bought back $134.6MM at an average price of $13.82 per share.

Tucked into the proxy, ACAS is proposing an interesting solution that would help both employees looking to exercise their in-the-money options and current shareholders who want to reduce the dilutive effects of the options.  By law BDCs can't issue shares below NAV without shareholder approval.  Typically this is a great protection as it prevents managers from increasing the share count, and more importantly their fees, at the expense of current share holders.  ACAS is requesting the ability to tender employee stock options and issue shares covering only the net after-tax gain amount on employee's options, versus the entire amount via exercising the option.  Essentially this would drastically reduce the amount of shares that would be issued below NAV due to employee stock options.  This maneuver may also additionally reduce the selling pressure by encouraging employees to hold onto to their newly issued shares.  They won't need to sell for tax reasons (the company would pay out the amount due in taxes in cash), and you'd reasonably assume that if they haven't exercised their options and sold already, they believe the shares are undervalued and would continue to hold their exercised shares.

Here's the example they use in the proxy filing:
Using current market prices and the actual ~32 million options outstanding number should actually produce a better result than the example above since options are worth less at the $12.50 stock price, meaning less cash for taxes and less shares issued below NAV.  It seems like a win-win both for share holders and employees, and I hope it passes.

Since the employee stock options will either be exercised or out of the money after the spinoff, another one of the proxy proposals is for the 2016 incentive plan.  The plan calls for an additional 8% of shares to be set aside for employee options and another 0.5% for non-employee board members.  This might strike some as just another round of management raiding the cookie jar but if the current management options are gone, then this new plan kind of presses the reset button, almost like a new spinoff issuing the new management "founder" incentive options.  Not ideal, but not completely terrible either as they're not immediately dilutive, although issuing any shares/options below NAV is going to be dilutive, so it's a careful balance.  I'm willing to give them a break on it.  Management's record of share buybacks and now the tender offer tells me they're not quite as bad as their reputation suggests.

At this point, my biggest concern is around the timing of the spinoff.  It's been a long time in the making and if the option tender proposal isn't approved, I'm worried that management will put off the spinoff to allow additional time for employees to exercise their options and that would put more downward pressure on the share price.  Back in July I added some calls that expire in January, seems now that was a little optimistic hoping the spin would happen before then.  Either way, this is still one of my favorite ideas and I'll likely add to it before the year is done.

Disclosure: I own shares of ACAS (and Jan '16 calls)


  1. In the proxy you linked the pro forma balance sheet on page 18 lists $3.7B in ACAP equity vs your NAV estimate of 3.3/0.8=$4.125B. Where is your NAV coming from?

    In addition, New ACAS has $1.1B in equity (mostly CLOs and deferred tax assets). On an earnings basis New ACAS earned -$71M in Pretax income in 2014 and $78M in the first 6 months of 2015. You are valuing this segment at $2.1B (assets at book and presumably around 15x EBITDA for the management co).

    My concern in this story is that valuing assets based on NAV can be misleading because if the after-tax ROE is very low (like it is for this combined entity) it should trade at a discount to book value (and in this case book value is a bunch of level 3 assets). What do you think the normalized after-tax ROE is for New ACAS that justifies it trading at 1.9x book value?

    No recent insider buying (in fact lots of selling) is surprising if the undervaluation and path to realization is as straightforward as you argue.

    1. In the form 10, page 12, it lists the fair value of ACAP's assets at $5.832B and $1.749B of debt, so I just netted those to come up with $4.08B and did some rounding.

      I like the CLO assets, it's the right structure to invest in leveraged loans compared to a mutual fund or a BDC, they don't have to mark-to-market typically and they have semi-permanent capital where they can ride out any market disruptions without being forced to sell. Through the financial crisis, these assets performed well and typically have mid-teen like returns. So I'm perfectly fine valuing the assets at book, market might not initially agree with me, but I think it will get there. The historical earnings is a little misleading, they've added some CLOs this year, plus now they'll have the management contract with ACAP, once that's ramped up leverage wise they'll have another $7-8B in AUM at 1.75% + incentive, additionally they'll be expensing a lot of their costs through ACAP that will increase their profitability.

      Some of that is options being exercised (not all of it), that overhang and overall compensation sentiment is what's keeping the valuation down, I'd argue that it's not as bad as perceived (especially with the tender offer). It'll take some time for the value to be unlocked, probably takes 2-3 quarters of dividends at ACAP, continued fund raising at ACAS, but I think 9 months after the spin the combined entity is significantly higher.

      Thanks for reading, good comments.

  2. I agree that the catalysts for this idea are legitimate - paying a dividend should increase the valuation by some amount.

    However, to really be confident in an idea I'd rather the thesis be "the combined entity is cheap on normalized earnings to shareholders" and not have to rely on yield pigs paying huge premium for the worst part of the business. The fact that fees are moving from one entity to another shouldn't impact earnings for the combined entity.

    Love the blog

    1. Also forgot to mention perhaps the CLOs are great investments but the employee comp is so high that shareholders don't see a great return. Earnings are obviously lumpy here because of portfolio revaluations but New ACAS lost money in 2014 and is on track to make $156M pretax in 2015. You are valuing it at 13.5x 2015 pretax earnings but it sounds like you'd argue those earnings will increase because of higher fees on the spinoff and more AUM as the spinoff levers up....but what does that get you to....8x pretax?

    2. I tend to agree with you, there's no real magic to the spin if it was just taking an expense from one pile and making it a revenue to the other, but I think there's more at work here because ACAS manages a lot of other capital (say compared to FSAM/FSC or AINC/AHT) and the NOL. ACAS has been punished for doing the right things (outside of granting a lot of options at the bottom), cutting the dividend and instead buying back stock. Also, ACAS has been underlevered for a while now, I don't know the historical reason for this but they've been actively adding liquid syndicated bank loans and placing leverage on those assets to improve their normalized earnings, they need to add about $2B in assets to ACAP to get it close to peers leverage wise.

      And sure, the new ACAS valuation is kind of a swag, I think most of the disconnect to fair value is in ACAP and getting that to trade 85-90% of NAV.

  3. Worth remembering that the pure play CLO guys trade at a deep discount to BV, generally in excess of 30%. Not sure if that's justified, but most people tend to give little credit to the earnings power of the managers. Check out tetragon for instance. Any thoughts on that in general, and in reference to your valuation of ACAS?

    Also, there's no such thing as a liquid bank loan ;)

    1. I've briefly looked at Tetragon in the past, seems like a similar story there as well, but with new ACAS its an asset manager first and a bucket of CLO assets secondarily, so I don't think a 30% discount is justified for either but especially for the new ACAS.

      And yes, liquid is the wrong term, some floating rate mutual fund or ETF is going to blow up because loans aren't liquid (takes ~20 days to settle a loan), what I should have said is that they're moving more towards broadly syndicated loans that are in every CLO, marks are straight forward, less illiquid stuff than what got them in trouble during the credit crisis.

  4. A few more thoughts now that they're 3-year forecast presentation has come out:
    - One of the main criticisms around ACAS has always been their compensation, they laid out pretty drastic reductions in both salary and non-cash stock compensation
    - They're AUM growth assumptions look a little rosy on the public vehicle side since all of them now trade below book value, the tide might come back in for them, but it's hard to count on equity raises; but I think they'll be able to add other strategies and keep building their CLO platform, net-net their 10% AUM assumption is probably good
    - I must have misread/misunderstood their strategy for ACAP previously, they've been adding senior floating rate loans recently but now the plan is to move away from those, don't know if that's a result of relative value in the market or because ACAS thinks they can justify a greater fee?
    - And yes, they went the opposite direction, ACAS is increasing their base management fee on ACAP to 2% (roughly 2.5% with expense reimbursement) but will temporarily waive the management fee on the floating rate bank debt as a concession until they recycle those funds into middle market loans

    Overall - My view is still the same, but I might be quicker to dump ACAP at more of a discount to NAV as the fees are higher and the holdings are more opaque, 8% ROI to shareholders doesn't lend itself to trading at a premium.

  5. Elliott has gone activist on ACAS, encouraging shareholders to vote against the spinoff. Their presentation seems mostly a rehash of previous management mistakes, but I do have to spend some more time thinking about the risk of losing the ACAP management contract at some point. TICC and now FSC ( are both under pressure to lower fees/change management, seems like that's a greater risk now that ACAS went in the opposite direction and raised the proposed base management fee at ACAP to 2% (really 2.5% with expense reimbursement). I'll be curious to see how management reacts.

  6. Nice price action today after management's positive comments and increase in stock buyback

    1. Agreed. Any pressure on management to increase buybacks, reduce compensation is welcome, I still think the spinoff would be the best route to take. Would it be crazy to create ACAP as an internally managed BDC and leave the other management contracts at ACAS, split the team up. Just spit balling, but glad to see a fire was lit under them.


    Short thesis on ACAS.

    Valuing all Level 3 assets at 50% of their mark (including the CLOs) seems a bit extreme. I do want to dig into the ACE III story more, I'm guessing the author is mixing and matching ownership percentages but I saw plenty of asset managers selling securities into public vehicles at inflated prices first hand before the great recession, doing it the opposite way is just as bad. If true, that's the most damning.

    1. My main concern with this idea has been that, while the stock trades at a discount to BVPS, it is not cheap on an earnings basis (low ROE) and management has a bad track record, little ownership, and is selling consistently.

      I thought this thesis was concerning because it raised reasonable concerns that low ROE is caused by greedy/dishonest management rather than greedy/honest. Related party transactions are rarely good and it seems like these guys have a bunch of them. In addition, it sounds like the equity assets the company owns are terrible (HVAC contractor, blind retailer....yuck!).

      MMAC is a similar story (except it's not technically expensive on PE because MMAC actually realizes GAAP gains when they sell stuff) but, critically, management is behaving in a way that confirms the cheapness (really aggressive insider buying and stock buyback) whereas ACAS management could just be using the stock buyback as a way to cash out their generous options grants at higher prices.

      Love the blog.

    2. I also prefer MMAC to ACAS, but just hard to let go of such a large discount to NAV here. Especially now with Elliott involved, hopefully many of the governance and overcompensation issues can be reined in a bit, or miraculously they can convince someone like Ares to bail them out at a price that makes sense for both sides. Thanks for reading and the kind words.

    3. I commented about ACAS on your MMAC with a similar thought. Vote to replace mgmt with any 1 of the HF holders that has a Credit group in place. Whoever gets the mgmt contract poaches any of the good legacy ACAS employees for additional talent, then fire everyone else and charges a lower mgmt fee so that the assets can give you an ROE worthy of a valuation near BV. Boom.

      Must be some obstacles I haven't though got of, otherwise Goldman wouldn't be involved.

    4. That's essentially what's happening over at TICC right now, asset managers are in a bidding war to take on the management contract, and that's what Elliott is arguing would happen to ACAP if it was separated from ACAS. I think the trick is how to separate ACAM from ACAS, I don't think your solution would work with the other management contracts they have (mREITs, ACSF, CLOs, private equity). Could they do a reverse morris trust where ACAP gets spunoff and immediately merged with another BDC? That would maintain the NOL and the asset manager at ACAS, they'd just be managing less money, but their current mark on ACAM doesn't include the ACAP assets. Either way, there are a few junior bankers at Goldman who have cancelled their holiday plans, let's see what they come up with?

  8. ACAS has been cleaning up their balance sheet, in addition to the CLOs and senior floating rate debt sold in Q4, they've sold SEHAC (Service Experts - the mark in question on the short piece):

    And they've also priced a new $405MM CLO that closes in April, likely with many assets coming from ACAS's balance sheet.