I wanted to give all our readers a quick update on the Distressed Debt Investors Club. Each week we are getting more and more member and guest application and we could not be any happier with the growth and progress of the site. Throughout the second half of the year I plan on devoting a significant amount of resources to expand the functionality and membership of the site. Currently we have nearly 1500 guests and 140 members. As mentioned in previous posts, the membership for the site closes when we get to 250 members so I encourage those that are interested to apply - you get access to all the previous posted ideas and the Distressed Debt Investors Club forum, a place where I am posting 2 to 3 times a day.
With that, and I try to do this once every few months, I provide you with a recent idea submitted to the site: American Capital (ACAS) [Note - All attachments have not been included in the below write-up. You will just have to join the site to get the 17 page supporting attachment]
ACAS is potentially undervalued relative to the fair value ("FV") of its investment portfolio and its earnings potential as measured by NOI. Meaningfully more leveraged than its peers, ACAS is currently going through a balance sheet restructuring. In the past management was able to leverage the business through issuance of on-balance sheet unsecured obligations-- a capital structure strategy that is unsustainable given the volatility of the underlying assets. The reorganization plan calls for the use of the company's large cash position to pay down debt and exchange unsecured debt for secured issues. More equity has been raised (including appx. 58mm shares 75% of which was sold to Paulson & Co. -- on appx. 280 mm existing) Additionally, in the future, management hopes to sustain leverage through securitization trusts, which has been a successful source of low-cost funds in the past.
There are several catalysts that may realize value in the short term/medium term:
(1) Finalization of the exchange offer/presentation by management with PF-capital structure and business projections.
(2) Continued realization of its current investment portfolio at or greater than FV.
(3) Eventual reinstatement of the dividend on a cash basis.
(4) Mark up of European subsidiary European Capital "ECAS."
ACAS is a business development company "BDC," a form of publicly traded private equity vehicle in the United States. Historically, in the United States, there had been a group of publicly traded private equity firms that were registered as business development companies (BDCs) under the Investment Company Act of 1940.
Typically, BDCs are structured similar to real estate investment trusts (REITs) in that the BDC structure reduces or eliminates corporate income tax. In return, REITs are required to distribute 90% of their income, which may be taxable to its investors.
Relative to other BDCs, ACAS's investment portfolio has a higher concentration of equities leading to a more volatile asset base. BDCs generally trade as a multiple of book relative to the FV/Cost of the investment portfolio.
Valuation was looked at three different ways:
(1) Current NAV/Share
(a) 5% discount
(b) 15% discount
(c) 35% discount
This indicates potential upside of (-3.4% to +41.2%) or an expected value of (+21%)
(2) Multiple of FYE 2011 NOI:
(a) Base Case: Asset leverage of 45%. Asset Interest Income Yield of 13%. Equity Dividend Yield of 5.5%
(b) Low Case: Asset leverage of 40%. Asset Interest Income Yield of 13%. Equity Dividend Yield of 4.0%
(c) High Case: Asset leverage of 50%. Asset Interest Income Yield of 14%. Equity Dividend Yield of 6.5%
This indicates potential upside of (-32.2% to +90.4%) or an expected value of (+23.3%)
(3) Comparable Basis:
(a) Min, Max, & Median multiples of NAV/share
(a) Min, Max, & Median multiples of FYE 2011 NOI
This indicates potential upside of (-1.3% to +135.5%) or an expected value of (+45.0%)
Taking it all together:
(1) Even if the reorganization is successful, a worsening of the macroeconomy will negatively effect the fundamental performance of ACAS's investment portfolio companies. Coupled with a further contraction in middle-market transaction multiples, there may be an even more significant decline in the FV of the portfolio.
(2) It is unclear how an inflationary environment will affect the business:
(a) On the one hand, the interest income will rise as rates rise, but,
(b) Inflation may erode fundamental value at the portfolio level.
(3) Any liquidity crisis will make portfolio realizations and further balance sheet restructuring difficult to execute.
(4) It is unclear how dilutive future equity offerings may be (esp. at a discount to book) although it seems that management is very valuation sensitive to this risk.