Will American Capital Ltd. Address Its Biggest Problem?

Photo: Tax Credits

American Capital Ltd. (NASDAQ: ACAS  ) is getting a face lift. Or so it seems.

After halting its buyback program, the speculation is that American Capital will work to spin-out one of its best assets -- the asset management company, American Capital Asset Management.

The asset manager earns huge fees for managing American Capital Mortgage (NASDAQ: MTGE  ) and American Capital Agency (NASDAQ: AGNC  ) , among other funds. With asset managers trading at a premium, it seems like an easy way to create value for shareholders.

But while we're on the topic of creating shareholder value for American Capital Ltd. shareholders, let's talk about the elephant in the room: Big paydays for executives.

Would you like options with that?
American Capital's insiders love to award themselves with big paydays in the form of stock. And it's not just an American Capital Ltd. problem. It happens at American Capital Asset Management, too.

Let's look at the numbers. The chart below compares stock-based and other compensation at American Capital Asset management to net operating income by year.

Pay for performance doesn't seem to exist. In 2013, American Capital Asset Management added only $296 million in fee-earning assets, according to its fourth-quarter presentation. That would translate into less than $4 million in annual revenue at an average fee of 1.25%. Despite this unimpressive performance, other compensation tallied to $55 million last year.

American Capital Asset Management is just one piece of American Capital Ltd puzzle, however. The holding company reveals even more stock-based compensation, this time in the form of American Capital Ltd. stock options. The annual report shows 54.1 million options at a weighted-average price of $9.13, well below the company's current price.

If exercised, American Capital shareholders would see the total diluted share count, adjusted for first-quarter buybacks, surge by an incredible 18%. I'm not surprised, either, to find that the buyback ended at a convenient time for insiders. Some 49.6 million of the 54.1 million options outstanding have exercise prices below the current share price.

Two birds with one stone
While American Capital Ltd. debates the best way to create value for shareholders, investors should continue to ask if they're getting what they're paying for.

American Capital's long history of aggressive stock issuance likely won't stop after a spin-off, and shareholders should question if the most obvious way to create shareholder value isn't with financial engineering, but reigning in excessive executive compensation.

A spin-off may change the company, but if it doesn't change the culture, the long-term benefits may flow first management, and secondly to shareholders.

It's high time for shareholders to be treated like investors, not second-class citizens.

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  • Report this Comment On April 08, 2014, at 1:54 PM, foxyxi wrote:

    I may be missing something, but this doesn't at all appear to be an ongoing issue. A significant number of shares were issued in the 2008-2010 crash, but the issues options is actually decreasing now. Looking through the history of annual reports yielded these results for available options and strike prices:

    Year: Issued: Strike Ave:

    2013 54.1M $9.13

    2012 58.2M $8.72

    2011 58.9M $8.03

    2010 39.8M $7.18

    2009 26.2M $9.35

    2008 26.0M $34.91

    The only thing I don't understand is how the 2008 to 2009 transition had the stock option strike price change.

    However, it seems fairly clear that the ongoing issue of options is not a concern of the scope that you are describing. In fact, going through the buyback announcements and quarterly results shows that in 2013 there were 6.2M options exercised and the issued options decreased by 4.1M, for a net issuance of 2.1M options. This is about 0.7% of the average share count for the year.

  • Report this Comment On April 08, 2014, at 2:07 PM, foxyxi wrote:

    Oh, another thing about stock options is that if exercised the company does receive money, which offsets the dilution. For example, if all options exercised today ACAS would receive $494M, which if they were to use for a buyback at $15/share would result in a net increase in shares of 21.2M. As the share price goes up that of course will affect the equation, but because the company gets a half billion dollars it must be included in any dilution calculations.

    Sure, it would be great if there were no outstanding options. On the other hand if everyone had jumped ship in the crash and the company dissolved that wouldn't have worked out too well for shareholders.

  • Report this Comment On April 08, 2014, at 8:45 PM, TMFValueMagnet wrote:

    There's an obscure rule that requires options issuance to stay under 20% of the share count. Very few options can be issued today without going over the limit. (Interestingly, that rule would no longer be in play if ACAM becomes American Capital Ltd. and the other assets are spun out.) Recently, options have mostly just churned over as they are exercised and replaced with new ones.

    On the topic of option repricing, American Capital made a tender offer for employee options and canceled them during the financial crisis. They were then handed back out at lower strike prices. If it weren't for that move, most would have expired worthless.

    You're right about the total dilutive effects.

    However, my concern is that ACAM is rewarding its employees very well, even in a year when AUM growth was weak, at best. If the spin-off happens, not only will management have free reign to issue whatever level of stock-based compensation they desire, they'll also have the ability to pay themselves in very pricey currency -- ACAM equity.

    American Capital Asset Management is by far the best asset at American Capital. What happens when American Capital executives are at the head of ACAM, and have a limitless ability to issue new shares?

    If the past is any indication, more dilution will likely follow the spin off.

  • Report this Comment On April 10, 2014, at 12:52 PM, spokanimal wrote:

    Your analysis is correct. Share buybacks often mask the dilutive impact of excessive options grants to insiders. Without the buybacks, rising float (diluted) is more obvious and irritating to investors, but with ACAS's declining float amidts it's large buybacks, the company's over-compensation is less transparent.

    There are many reasons why ACAS trades so far below NAV. The company's excessive, non-cash compensation isn't one of the biggest reasons for that, but it certainly plays into MY decisions on what the discount to NAV must be before I will accumulate shares in this operationally-challenged company.

    Spokanimal

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