As the credit crunch rolls onward, Wall Street seems to be heeding one piece of Polonius's advice from Hamlet: "Neither a borrower nor a lender be."
Polonius may be on to something, since nearly all the market's lenders have sold off sharply and indiscriminately. But amid this chaos, enterprising investors may be able to find a few treasures tossed out with the trash -- such as American Capital Strategies (NASDAQ:ACAS), the premier business development company (BDC).
We offered a brief introduction to American Capital last year. Earlier this year, Motley Fool Income Investor discussed the company in more depth in an official recommendation. It's time for an update on how our "investing gorilla" is holding up in the current environment.
Recession fears
Lending money to companies is a BDC's bread and butter, and like other lenders, BDCs suffer when their customers don't pay. BDC stocks have taken a beating amid investors' concerns that housing troubles will drag the United States into economic recession. Already tapped-out consumers, in hock up to their eyeballs, may be forced to cut back spending, making it even harder for the companies from which those consumers usually buy things to keep current on debts to lenders like American Capital.
During the last economic slowdown following the Sept. 11 attacks, American Capital's nonperforming loans rose as high as 15% of its lending portfolio (measured at original cost). When the resulting losses hit the books in 2002, the company's stock price was nearly cut in half. Mr. Market seems to be afraid that 2008 may be shaping up the same way.
But that scenario might not be such bad news for American Capital shareholders. During the 2002 recession, American really showed its colors. The high interest rates it charges (currently topping 12%) allowed it to recoup most of its losses. And its modest financial leverage (by law, BDCs are limited to supplement their equity capital with at most an equal amount of debt capital) limited the extent of the damage. Meanwhile, more highly levered competitors were forced to retreat, leaving American practically the only game in town. The company was able to deploy its dry powder on very favorable terms, making a number of investments that have subsequently performed spectacularly well.
Current loan performance
For all the gnashing of teeth, American's portfolio still seems to show few signs of a recession. Nonperforming loans (which spiked to 15% in 2002) are holding steady at 5.5% of the portfolio -- near record lows for a BDC. Meanwhile, the current credit crunch is driving competitors back, giving American more power to invest on better terms.
American is starting to lick its chops again, touting the excellent investment opportunities available. This Fool doesn't doubt that the economy will take a turn for the worse. But as long as the company sticks to its strict due diligence and underwriting discipline (it funds less than 2% of the deals it reviews), there's every reason to believe it will navigate choppy waters as successfully as it handled the storms of 2002.
Equity portfolio
Apart from loans, American Capital also invests a significant part of its portfolio in equities. Almost half of its investments come from buyout transactions in which American takes a controlling equity stake in addition to providing debt financing. These investments provide private equity-like returns, typically greater than 20% compounded.
Of course, in recent years, as more money has chased these private equity returns with easy credit, prices have gone up, stressing both risks and returns. However, American seems to have maintained its discipline. During the recent capital crunch, it's so far needed to write down only a few percent of its recent equity investments.
Of course, illiquid investments such as private equities always raise questions about valuation procedures. After all, there are no public market prices quoted for private assets, and managers always have an incentive to avoid booking losses. Berkshire Hathaway's (NYSE:BRK-A) (NYSE:BRK-B) Warren Buffett voiced these concerns in criticizing the proposed bailout fund for structured investment vehicles (SIVs): "I think there should be a requirement that ... 10% of the holdings should be sold into the market to people who are not associated.... That way we can be sure that they are being put in at appropriate market prices."
Unlike some other financial companies, which seem to have remained in denial about their deteriorating assets, American Capital has done exactly as Mr. Buffett suggested. It's sold a broad cross-section of its equity portfolio, which it spun out into a couple of private equity funds. (More on those in a moment.) Independent and knowledgeable third parties have proved willing to pay full price, soundly validating American's valuation of these illiquid assets.
All in all, American's core portfolio of debt and equity seems to be performing well and valued appropriately. Continued management by talented professionals should generate attractive risk-adjusted returns going forward.
Asset management
Recently, American Capital has begun to employ its solid 10-year track record of managing mezzanine and private equity-type investments to begin building out an asset-management franchise. Rather than risking its own capital, it's receiving attractive fees to act as a fund manager -- generally in line with the industry standard of a fixed annual fee of 2% of assets, plus 20% of profits above some hurdle rate. Beyond its reputation as an investor, American has a competitive advantage over funds that raise blind cash pools. It can incubate assets by buying and holding them on its own balance sheet, giving investors a chance to review quality samples before they commit capital.
So far, American has successfully incubated three major funds, together totaling $4.2 billion in assets under management, on which it earns a 2% annual management fee plus a cut of the profits. If those profits are anywhere near the returns the company has generated on its own balance sheet, the asset management ought to average revenues of at least 4% of assets under management, or $168 million per year.
Assuming that operating expenses consume half that revenue, American would have $84 million in net income left. The company carries this business on its books at $562 million -- less than 7 times projected income, and less than 10 times the actual net income booked from these operations over the past 9 months alone. This kind of valuation is no stretch by any means, and it holds great promise for rapid growth as American Capital incubates and rolls out new funds currently in the works.
However, American's valuation of its two-thirds equity stake in similar firm European Capital is another matter. European's share price has plummeted since its IPO, yet American Capital has avoided taking a writedown here, citing some dubious accounting principles that allegedly require the company to write up the asset above market value. Happily, European Capital's public listing makes it easy to separate these figures from American's balance sheet. European currently trades at about $11 per share, which values American's 71-million-share stake at about $780 million -- or $240 million less than American's carrying value.
Securitizations
The 8% of American's portfolio invested in commercial mortgage-backed securities (CMBS), collateralized debt obligations (CDOs), and other structured finance investments also deserves extra scrutiny. These assets are the same types making headlines every day; no buyers can be found for them, and their market values are dropping precipitously.
In all fairness, American Capital's CDOs have no exposure to the subprime disaster. The underlying collateral seems to be levered corporate loans, which have not shown a great deal of stress. The CMBS assets have very different characteristics from residential mortgages, and ACAS reports that every dollar of principal is current on its payments.
In that light, the writedowns that American has taken on these assets (now carried at a 7% discount to cost) seem adequate. Still, it would be rash to ignore the severely adverse reaction of the secondary market. Instead, we will prudently assume that this part of the portfolio is at risk of writedowns totaling another 18%, adjusting the fair value down to 75% of cost. This reduction (what's called a "pro forma" or hypothetical valuation adjustment) implies another $70 million markdown of American's net assets.
Valuation
All told, our critical review leads us to knock $310 million, or just shy of $2 per share, off American's last reported net asset value of $34.92 per share. Friday's closing price of $35.46 per share amounts to a scant 2% premium over adjusted book value. It ascribes almost no value to American's high-quality management or further accretive equity offerings. In fact, a market value of 1.10 times NAV constitutes a multiyear low. Since coming public, American has tended to trade at valuations closer to 1.5 times net assets. Clearly, there's room for substantial upside in the share price.
Dividend-wise, American intends to pay a total of $4.19 per share in 2008, amounting to a rich 11.5% forward yield. Given that American Capital will start off 2008 with a cushion of almost $0.90 per share in the bank as undistributed taxable income, it's no wonder that the company is comfortable forecasting 13% growth in per-share dividends and 23% total returns, even in the absence of multiple expansion.
I see much the same picture, and I recommend that interested Fools consider looking into American Capital.
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