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American Capital Ltd. Just Got A Killer Deal


American Capital Ltd. (NASDAQ: ACAS  ) is in the midst of what many believe to be a massive transformation from asset owner to asset manager.

During this transition period, American Capital is piling up cash. Historically, cash on the balance sheet was immediately used to fund share repurchases. Now, however, repurchases are off the table, as further buybacks would violate rules on insider ownership and stock-based compensation.

So what's American Capital to do with all that cash? Invest in senior loans, apparently.

New firepower
In the first quarter, we learned American Capital invested $199 million into liquid, senior floating-rate loans. These loans aren't typically what you'd find in a business development company. The borrowers are larger and more established, and the yields are low -- just 4.5% on average, according to the company's latest filing. That's roughly in line with the yields reported from the S&P/LTSA U.S. Leveraged Loan 100 Index. 

Although these are low-yielding assets, American Capital can still generate a respectable return. We learned on Monday that the company obtained a new credit facility from Bank of America at a rate of LIBOR + 1.6%.

This may be the cheapest credit facility of any BDC. The pricing, though, is obviously the result of the fact senior floating-rate loans are lower-risk investments. Pricing would be much higher if it were secured with middle-market debt investments. (Its other credit facility, secured by riskier assets, costs 3.5% per year.)

Back of the envelope returns
Going quickly to potential returns, let's do some quick back of the envelope expectations for this new credit facility.

First, what we know: the 1-month LIBOR sits at 0.15%, and American Capital's senior floating-rate loans had a weighted average yield of 4.5% in the first quarter. Assuming 1:1 leverage, we get a return on equity of 7.25%, before any credit losses.

Based on discussions from the previous conference call, however, there's potential for greater than 1:1 leverage in this particular vehicle. Leverage of 1.5:1, for example, would boost returns on equity to 8.625%; again, this is before any credit losses.

Respectable returns given bottom line weaknesses
American Capital's biggest problem is that although it's asset rich, it's income poor. The bulk of its equity assets were generating very little income. Those are now largely off its balance sheet.

Reinvesting the cash raised from asset sales into floating rate loans should help headline earnings. After all, using a baseline 7.25% return on $750 million of equity levered at 1:1 adds roughly $13.5 million in quarterly interest income.

Last quarter, the company reported a total of $16 million in net operating income, a figure which excludes the impact of unrealized and realized gains. Once American Capital is fully invested in senior floating rate loans, net operating income would likely double from the first quarter of 2014.

The last word
Deploying capital in senior loans will help net operating income, which has been in decline for quite some time. The real question now is one of permanency: Will senior loans forever be part of the American Capital balance sheet?

Will these assets eventually become a new, publicly traded fund from which American Capital can draw management fees, much like American Capital Senior Floating Rate (NASDAQ: ACSF  ) ?

Or is this just a way to bridge the gap and spruce up earnings while American Capital transitions from an asset owner to asset manager?

I don't know -- there's no way to know. But one thing is for certain: American Capital got a great deal on this credit facility, and, for the first time in a long time, net operating income should finally be on the rise once again. 

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Read/Post Comments (4) | Recommend This Article (4)

Comments from our Foolish Readers

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  • Report this Comment On June 30, 2014, at 5:49 PM, AlonzoChurch wrote:

    Hi Jordan,

    You wrote: "Now, however, repurchases are off the table, as further buybacks would violate rules on insider ownership and stock-based compensation."

    That's new to me and very interesting.

    Where'd you get that? Violate how?


  • Report this Comment On June 30, 2014, at 6:35 PM, TMFValueMagnet wrote:

    The stock option thing is obscure, to say the least.

    In the most recent DEF-14A filed in April, you'll find the following language:

    "Moreover, under the 1940 Act, the number of options that we can have outstanding is limited to no more than 20% of the outstanding shares of our common stock, and the number of outstanding options is close to that limit."

    American Capital's quarterly filings aren't much help in the stock option department. The best breakout was in the 10-K, where ACAS had 54.1 million options outstanding vs. 304 million fully diluted shares at that time. Share count was last reported at 283 million in diluted shares, perilously close to the 20% limit.

    Anything greater than an immaterial buyback would reduce the denominator to an extent that stock options for insiders exceed the 20% limit enforced by the '40 Act.

    Hope that helps.

  • Report this Comment On June 30, 2014, at 10:00 PM, AlonzoChurch wrote:


    I knew they were pretty generous to themselves with options but I didn't know it was 20% of the company.


  • Report this Comment On July 01, 2014, at 8:09 AM, TMFValueMagnet wrote:

    Thanks for asking, Jim.

    I'd say generous is an understatement. Options were culled during the downturn, and subsequently repriced and reissued.

    One of the biggest risks to the ACAS story is, in my view, the risk that insiders pay themselves even better as ACAS transitions to an asset management pure-play. Insiders will be able to dole themselves options on what is arguably the most attractive part of ACAS (ACAM).

    There's a lot to love about ACAS, but compensation is an obvious problem. It has been for a long time -- and I say this as a former ACAS shareholder who first found interest in the stock when John Paulson had to run away a few years ago.

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Jordan Wathen

"The liabilities are always 100 percent good. It’s the assets you have to worry about." - Charlie Munger

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