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American Capital, Ltd. Message Board

  • takecareandgoodluck takecareandgoodluck Jan 7, 2002 8:26 PM Flag

    Securitization

    Surprised no one has mentioned the securitization ACAS started at the end of 2000 and completed in Q1 2001 (perhaps I just haven't read far enough back on the post board, in which case I apologize if I am redundant).

    Just as a refresher the Company securitized $153.7mm of its portfolio loans. The $153.7mm was comprised of loans from 29 different companies and it was tranched into 3 groups, the Tranche A of $69.2mm, Tranche B of $46.2mm and the Tranche C (or first-loss piece) of $38.3mm. The ACAS Trust successfully syndicated the first two tranches, but ACAS retained 100% of the first loss piece.

    Because ACAS holds a majority of the equity in the Trust, it must continue to consolidate the entire Trust on its balance sheet, even though losses or gains on the first two tranches or non-recourse to the Company.

    I bring this up to help illustrate my previous point- the risk appetite of management of this company is completely skewed when compared to the investor base it has attracted over the past 12-18 months.

    Investors and the analyst community alike have championed this as a safe haven and a yield enhancer in a time of credit deterioration and falling interest rates. What happens when the credit cycle that follows companies who's cost of capital is 13.5% catches up to ACAS as I suggested in my previous post? What happens when management, already stretching for yield (e.g. taking down 100% of the first loss piece of a securitization) suddenly realizes it can't deliver on that nice, warm, comforting 8% dividend ...... I think you get my point.


    SOMETHING isn't right. If the Company truly is able to mitigate default risk to the meaningless number it currently suggest, then it must not lever its investments at all. But if that is the case, it can't possibly generate anything close to the growth on its equity investments that you need to invest at 1.75x book.

    ...truth is, they lever there investments, defaults will start flowing through and book value (excluding any future equity raises) is just as likely, in my opinion, to deteriorate as it is to appreciate. This will only be exacerbated if management effectively levers itself (as above) in an attempt to capture yield and preserve the dividend yield that has attracted much of the shareholder base.

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    • One of the questions raised has been how realistic is ACAS' default rate. I think a key difference is underwriting. It seems to me that a bond underwriter has a much different motivation (bobjones & takecare - feel free to chime in where I'm off base!). The bond underwriter seems mainly to be a salesman, that is sell the bonds to someone else. With Moody's and S&P, he doesn't have to do much leg work on a particular company. He doesn't retain much of the bonds, and really isn't impacted if they go south. He's collecting his money at deal time.

      ACAS on the other hand is dealing with companies so small that there is really no research available on them. ACAS has do the investigative work, and it's fairly thorough. In fact, the inital filing for GLAD some years ago was to form a corporate investigation firm. It usually takes about 3 months for ACAS to complete its DD, and in the end, ACAS rejects many more deals than they write. Additionally, to make sure there are no surprises, they almost always get a board seat. They do this because they eat their own cooking.

      Granted, does that deserve a 75% premium to book? Probably not, but ultimately it comes down to ACAS' ability to generate net operating income. I'll admit that 8% is low for ACAS, and is driven by market demand. At 9% yield, ACAS would trade at $25.33=(4 X $0.57 )/.09. So if you short at $29 and it drops to $25.33, that's 13%. But in three weeks, that will change when they announce the 1st Quarter dividend. If the dividend rises to $0.58, a 9% yield implies a $25.77 price. Or maybe because of the record amount of originations in 2001, the dividend will be $0.59, implying a 9% yield price of $26.22. Maybe we'll get lucky and the dividend will be $0.60 or $0.61. Then we have to consider how much they rise the 2nd Quarter dividend.

      The question you have to ask yourself, is the market buying ACAS because of valuation or yield?

      Later

    • takecare,

      After this post, I'm also done. (I had already told the board I won't be posting much here anymore, and then I proceed to post more than ever. Although, as an out, I said if I had something of interest to share...I'd be baaaack!)

      We look at things differently...I see the glass half full, you see it half empty. Another example is recurring income. The fact that the $10M+ in income fees is tucked in ACFS and is more than offset by salaries in ACFS, means nothing to me. You wanted to know if there was a recurring source of income fees...and there is. The fact that most fees and salaries reside in this sub and 'detract from the equity base', in my mind, misses the big picture. Overall operating expenses/assets are low BECAUSE expenses and fees are buried in this sub. If the sub didn't exist, I think you would better appreciate this recurring source of fee income.

      I believe analyzing any 'real' business as a 'liquidation' is the wrong way to go. (If you are going to do that, though, look very carefully at the sub debt valuation. As demonstrated in the Chance Coach post, sub debt's carried value is very different (and lower) than its face value or liquidation value.)

      The reason I think you shouldn't view this as just a bunch of overvalued 'junk bond assets' is because there is so much more to this 'value-added' business. ACAS has so much more control than a manager of a pool of junk bonds. ACAS has board participation in 90% of its portfolio companies and has second liens on 80% of them (ahead of unsecured debtors). Being the largest shareholder in many of these companies allows them to roll up their sleeves before a small problem develops into a large one. They have changed personnel at their portfolio companies and sometimes they've been forced to clean house. If things get real bad, they've structured their covenants at many companies to take control of the majority of the board.

      I learned a valuable lesson in the past year when trying to second-guess a perceived overvaluation in these BDC's. I thought ALD had over-reached in their core competency by extending credit to some shaky telcos. Some of these were publicly traded and they were near-basket cases. What I didn't know was where ALD had put themselves in the corporate pecking order in terms of a bankruptcy. I didn't know they had protected themselves by lending to the more financially sound holding company...or by some clever use of debt covenants. I know both ALD and ACAS actually wouldn't mind a strategic bankruptcy at some of their portfolio companies. (They've structured some deals, where they actually protected themselves so well, they would make out BETTER if the portfolio company declared bankruptcy!) This shouldn't be a shock to you because I'm sure you've followed the activities of many vulture investors. Marty Whitman bought over 50% of the sub debt of one of the companies I own...anticipating (actually hoping) to divvy up the spoils at an announced bankruptcy.

      ACAS has so many more advantages over the private equity funds they compete with that I can't help but think of this as a growth company. Most of their competitors are one shop outfits with a few partners running the show. ACAS provides much more transparency, safety, and liquidity than these limited partneships. ACAS has been one of the few firms that has been able to get the deals done in a really tough environment. A few years ago they were not well-known and might have been an after-thought as a source of capital for small and midsize companies...they are now close to being the first call.

      Good luck in whatever you decide with ACAS. I actually have mixed feelings. Operationally, large short positions would not be helpful to the ACAS business model, although personally it would allow me to buy at better prices. I think many would feel as I do (providing a floor), rendering a short position both uncomfortable and unprofitable over the long haul.<

    • Ok, last reply then I promise to sit back for a week or so and listen to others:

      I think we'll just have to agree to disagree JJR-

      "ACAS has a fully owned sub called ACFS. American Capital Financial Services gets most of the annual recurring fees, investment banking fees, advisory fees, and service fees. It also gets the lion share of paying employee salaries. The income fees will be well over $10M this year."

      That sub is consolidated on an equity method basis in ACAS's results. Since 1999, ACAS has yet to recognize a gain in its equity position in ACFS. i.e.- ACFS's fees have never covered its operating expenses, and will not again this year. I guess when I was calling for recurring revenue, I should have stipulated that I meant recurring profitable revenue that built, rather than detracted from the equity base of ACAS.

      As far as your comments concerning leverage, when comparing relative performance (i.e. ACAS vs. a high yield fund, for expample)- both can use leverage and both will use leverage. Still, given the current share price, ACAS's underlying portofolio must vastly outperform one structured very similarly for the stock price to appreciate more than the similar fund, as both can use leverage.

    • takecare,

      I agree that valuation matters...in fact, it's the single most important factor in my investment decisions. Where I disagree with you, is 'how' you evaluate ACAS. Ironically, ACAS is in the business of assessing a company's value...and would be the first to say that there is a huge difference between liquidation value and ongoing business value.




      "If ACAS can really establish itself in such a manner, and generate recurring fee income- I am willing to invest my $1 at a discount to net assets...That being said, while ACAS may be on track to do that, historical results don't lend much credence to that fact. "Interest and dividend income" represented 98% of total revenue last quarter. "Loan fees and other income" only $474,000."


      ACAS has a fully owned sub called ACFS. American Capital Financial Services gets most of the annual recurring fees, investment banking fees, advisory fees, and service fees. It also gets the lion share of paying employee salaries. The income fees will be well over $10M this year.






      "This sounds to me, a lot like a private equity shop, or an LBO fund. These shops focus on almost identical niche markets as ACAS- and have arguably more impressive people doing the investing. Standard fees for an investment in a KKR or Hicks Muse fund is 1% of assets plus 20% of profits."


      Aha, we are getting closer...but we're not there yet! Bigger isn't necessarily better or smarter. Hicks Muse and KKR seemed to have strayed a bit from their core competencies in the last few years...and had some big blow-ups in their respective portfolios to show for it. I would also have a hard time paying these ongoing loan shark rates to these big private equity shops. Both of these particular companies have zero interest in doing ACAS-size deals but there are literally hundreds of 'mom and pop' operations that ACAS competes against. This is a huge, fragmented market ($10B-$20B annually), which is begging to be rationalized. (BTW, ACAS has principals from some of these operations such as Hicks Muse. Give them a call and see if they agree if their former organizations have 'arguably more impressive people'.)





      "Everyone can use leverage...Leverage may boost returns, but it may also jeopardize that 8% dividend that many have clung to as the valuation floor for ACAS."

      You've made several points about the 'underlying portfolio' and use of leverage that I find misleading. Leverage is in integral part of ACAS' business model, as it is in almost every other well-run business. Comparing ACAS without leverage greatly distorts the true economic picture. As a BDC, it is allowed to lever up to 1-1. With current low-cost capital, a fully levered position easily adds 5 percentage points to its non-levered results. This is a financier, leverage is a big part of their business. (If I went to my local S&L (which I own), and asked them to compare their portfolio returns to mine...but asked them to eliminate their 15-1 leverage position, they'd laugh me out of the bank.) Well-run ongoing businesses, particularly lending institutions, all employ leverage...most much greater than ACAS. When GE bought Heller (at a significantly higher price than ACAS' current valuation), it was much more leveraged than ACAS.

      When you mentioned that 15% default ratios are the norm with this type of lending, it's interesting to note that ALD's 41-year record is less than 10 times that at 1.5%.

      When you mentioned that ACAS gets 13.5% on 80% of it portfolio, in actuality it's on the entire asset base INCLUDING non-interest bearing equity and quasi-equity. (In other words, the actual interest is appreciably higher on the interest-bearing loans).

      This is a poor short and a lousy hedge at current prices.

      Jim

    • takecareandgoodluck,

      I'm afraid most of us on this board fall into that category of 'simple folk'. By your postings, I have little doubt you are far more schooled in the ways of 'high finance' than any of us here. I, for one, do appreciate the main point you and bobjonespa are driving home, 'this ain't your father's oldmobile'!

      I grant you that ACAS' 8% dividend yield is far riskier than many of the 'senior citizen set' assume. However, my golden-ager-CD-investing-parents HAVE substituted a portion of their CD's to an investment in ACAS...and I think they've done it with open eyes.

      I'm also wondering if we don't understand your point of view a little better than you understand ours. There are definitely some risks here at ACAS' current price...but ACAS' structure and business model allow for far more price latitude than your assumptions seem to imply.


      It's also one thing to warn investors about ACAS' so-called safe dividend, but I'm afraid you lost me with some of the more strident comments. When you claim that, "SOMETHING isn't right...when management, already stretching for yield (e.g. taking down 100% of the first loss piece of a securitization) suddenly realizes it can't deliver on that nice, warm, comforting 8% dividend ...I think you get my point." I actually don't get your point. Can you explain to me in layman's terms how doing an on-balance sheet securization is 'stretching for yield'? The implication being that this is a far riskier way of raising money than borrowing it in some other manner. I liked the idea of 3 credit rating agencies going through the portfolio...giving ACAS another option for raising capital. Whether ACAS borrowed it through a revolver or securitized and retained the 'residuals (toxic waste to the doomsters)'...the credit risk remained the same.

      Jim

      • 2 Replies to JJR1998
      • JJR and Berkely Bob-

        "[takecareandgoodluck] I'm afraid most of us on this board fall into that category of 'simple folk'. By your postings, I have little doubt you are far more schooled in the ways of 'high finance' than any of us here."

        Ok, relax. I thought some of the posts on this board were excellent, and some of your replies, JJR, very thought-provoking. Truth is I may not be as eloquent in my financial analysis as you or some others on this board- and so I tried to keep my post very plain-english and to the point. If it came across as condescending, I apologize.

        "Also interesting, (and speaks to ACAS portfolio quality), there have been 8 exits in the last couple of years. In arguably the worst market in years, ACAS' exits had a weighted IRR of 27%. The worst performer produced 18% annualized, while the best produced 98% annualized. Interestingly, they were carried at lower unrealized values on the balance sheet."

        ACAS's portfolio is comprised roughly of 80% senior and sub debt and 20% equity and quasi-equity. If we assume a 13.5% annualized return on the debt portion of that portfolio (which would imply a 0% default rate, which as I've previously argued, is not realistic), then in order for ACAS to continue to post 27% annualized IRR's, the equity portion of their portfolio would need to return 81%. Just not sustainable in my mind.

        Despite some very thought-through posts, I still have yet to hear a convincing argument why ACAS can turn my $1 into $1.75. There is little/no recurring revenue here....no fee income- so you are left to rely on the asset management skills of ACAS senior management.

        They may be good, but I find it hard to believe that their UNDERLYING PORTFOLIO will outperform mine, or any index by 75%. The stock may- but that will only be due to the equity holders supporting their own value by attributing an artificially high premium to ACAS's investing skills.

        Bobberkely-

        we are so interested in analyzing this company b/c:

        1. it offers, to some of us, an excellent outright short- which can be just as profitable as long positions.

        2. it offers others who manage money, or even large personal accounts, an interesting way to capture spread (long your own portfolio at a 0% premium and short ACAS at a 75% premium).

      • There is nothing wrong with the securitization of the assets, you just have to realize that if your assets are the residual piece of the securitized portfolio - your returns are going to be magnified on the upside and downside. So if those loans were in fact money good - than great for ACAS - but if defaults do occur, than as a shareholder of ACAS you have to realize the effect of minor defaults in the underlying portfolio will be a more drastic reduction in your equity base than you might otherwise think.

        The fact that this vehicle is more levered than meets the eye only means that the equity base is going to be more volatile than the underlying assets. This speaks to both their ability to generate large returns if they are doing things right and the probability of significant capital loss if they run into problems.

        "Can you explain to me in layman's terms how doing an on-balance sheet securization is 'stretching for yield'? The implication being that this is a far riskier way of raising money than borrowing it in some other manner."

        The securitization effectively turbo charges the zero-default returns and turbo-charges the losses experienced from any default. If you truly believe in management's abilities it is probably a good thing. But keep in mind - since times have been good in the past year, if they did not have this "hidden" leverage, dividends would not have been as large.

        It is no more risky than borrowing money in any other way. (It is actually less risky if it is non-recourse to the other assets) But many times investors don't account for the volatility of these pieces and underestimate their change in value with respect to a change in underlying loan performance. Underestimating the cash-flow from the residual is equivalent to underestimating the potential loss in future dividends.

        But none of this really matters - and I really think I do understand your point of view. If these guys can replicate what they have done in the past and generate outsized returns on invested capital going forward into the indefinite future - the vehicle is structured such that a long term shareholder will benefit more or less wherever they decide to invest. If they invest when the stock is "expensive" than they just have to wait longer. If the loans continue to perform - you will be right.

        If these specific loans don't perform as expected- you still might be right - albeit over a longer time horizon.

 
ACAS
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