By Wall Street standards, American Capital (NASDAQ:ACAS) is noticeably mediocre. The fact is, it trades at a substantial discount to net asset value at a time when most BDCs are trading at a premium. Wall Street clearly isn't giving it any respect.
I've been spending some time to see why American Capital doesn't get love from Wall Street. On one hand, it has a great asset management business that spews cash. On the other hand, if it were to pay a dividend, it would yield substantially less than other BDCs.
Shareholders have largely explained the company's discount to NAV with the fact that it invests mostly in equity, not debt, so it has a lower potential dividend payout. I tend to agree, but there is one other fundamental problem investors would like to see fixed.
What's American Capital's portfolio worth?
So far I've come to the conclusion that American Capital's asset manager is probably worth its reported fair value. The same thing goes for its debt investments.
But what about the majority of the portfolio -- the equity investments that make up 53% of fair value of all assets at the BDC?
In 2012, American Capital took steps to carve out the company's debt investments and spin off a new debt BDC. The company believes a spin-off would help it create value for shareholders because investors who would prefer just the debt investments could own the spun-off debt BDC. Those who liked the equity investment could continue to hold their shares in a diversified growth company.
Spinning off assets and creating value are two different things, however. A spin-off doesn't guarantee value creation. It's likely not the cash-flowing debt investments that are being discounted. It's the equity investments -- the low-dividend, highly valued assets that constitute a majority of the investment portfolio -- that are getting a discount by Wall Street.
What we know about American Capital's equity investments
BDCs are notoriously opaque. Portfolio company investments are held as investments, so the operating metrics of its portfolio companies are not available to shareholders, individually or consolidated.
American Capital has made some improvements in disclosure. It now breaks out some consolidated financial data for its 42 majority-owned portfolio companies on slide 71 of its most recent quarterly financial supplement. These aren't its only equity investments, mind you, but majority owned portfolio companies make up the majority of equity investments at the firm.
Here's the slide:
By all measures, its portfolio companies look great. But this is non-GAAP information that doesn't follow accounting convention. For one, the adjusted EBITDA figures include either trailing 12-month or forward 12-month expectations, as well as adjustments that a new buyer might make in a change of control transaction. In short, it's an estimate, nothing else. The same goes for reported capital expenditures, which are reported as the same trailing 12-month or forward 12-month expected numbers.
The slide does provide some insight into why American Capital's equity portfolio may be such a low-yielding asset class: Its portfolio companies are heavily indebted. As a whole, they owned assets of $4.5 billion and carried total debt of $3.7 billion. Given that these are highly levered, middle-market companies, we can assume they're paying 10% or more on their debt in interest expense, eating up much of the cash flow that would come from the reported adjusted EBITDA and capital expenditures.
Better disclosure should be a priority in 2014
It isn't easy to put 42 portfolio companies on the same accounting program. American Capital has been at it for more than a year. But when they do get all of their portfolio investments together on consolidated financial statements, Wall Street will find it much easier to ascribe value to its underlying portfolio companies.
Failing that, it can publish a fully consolidated set of financial statements in 2014, some equity sales -- which have been moving at a snail's pace in 2013, at $42 million as of June 30, plus an additional equity exit in August for $23 million -- would improve Wall Street's perception of its stock investments. Luckily, its European subsidiary has been much more active, reporting 201 million euros in realizations in the first half of 2013. The cash was used primarily to repay debt on the books of the European fund.
If there's one thing American Capital can do by 2014, it's getting all of its portfolio companies on the same accounting standards, and making this information completely clear to investors who want to own the equity assets. Some new exits by the end of the year would help, too, given that companies are selling for higher and higher multiples of EBITDA in a robust bull market. Otherwise, American Capital is likely to continue trading at one of the biggest discounts to book value in the BDC universe for some time to come.