American Capital Ltd. Builds on Its Best Business

The oddball BDC, American Capital  (NASDAQ: ACAS  ) , is getting some respect for what it does well: investing in collateralized loan obligations.

The company calls this arm its "structured credit" division, and although it's small, it does have the best historical record within the company. Historical returns show an internal rate of return of 16% on its CLO equity investments.

An emerging asset manager
In the last two years, American Capital has served as a manager of four new CLOs from which it earns management fees in addition to the returns from retained equity interests.

CLO

Size

Fees

ACAS CLO 2012-1

$351 million

0.42% management fee plus 20% incentive fee

ACAS CLO 2013-1

$402 million

0.50% management fee plus 20% incentive fee

ACAS CLO 2013-2

$401 million

0.42% management fee plus 20% incentive fee

ACAs CLO 2014-1

$619 million

0.50% management fee plus an unknown incentive fee

Notably, the latest CLO, which was announced on Wednesday, may not be the last in 2014. A search of Cayman Islands business and trust listings reveals a filing for ACAS CLO 2014-2.

Before getting too excited, though, it's worth mentioning that the Caymans search also shows a second planned CLO from 2007, one which never came to fruition.

And although the company generates substantial fee income for managing these CLOs, it comes with substantial risk. American Capital retained 21-70% of the equity interests in each CLO listed above. Poor performance from any given CLO will easily wipe out the benefit of management fee income.

For illustrative purposes, note that American Capital owned a $50 million stake of the riskiest tranche of its first 2013 CLO, which dwarfs the baseline annual management fee on $402 million in assets. On the other hand, the most recent marks for its 2007 CLO show relatively good performance, especially when one considers the fact that it was raised at the top of the last credit cycle.

American Capital's breadwinner
Structured credit has an outsized impact on American Capital's bottom line. At the end of last year, the company marked its structured credit investments at $276 million. But interest income tallied to a whopping $72 million.

To put that in perspective, structured credit made up 4.5% of the asset base, but 14.8% of the company's revenue.

The disparity is due to two factors. First, CLO equity returns, before defaults, easily venture into the midteens, exceeding the yields from any other asset class. Secondly, last year, American Capital Ltd. had substantial middle-market equity investments on the balance sheet which were generating very little income at all. American Capital parted with the bulk of those assets when it sold its equity interests to a new private equity fund in which it is a co-investor and the asset manager.

American Capital's next quarterly filing should show a "new" American Capital, devoid of most of its nonincome-producing equity investments, alongside a beefed up asset management business, which should get a higher mark next quarter on the back of recently raised funds and the improved performance of its public mortgage REITs. Good for American Capital.

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