American Capital Ltd. (NASDAQ: ACAS) reported earnings below Wall Street's expectations, and the stock was punished. Shares were down 7% in the Tuesday session following an after-hours press release.

The biggest anchor on earnings this quarter was its asset manager. It can be a great business if assets under management grow. However, when assets decline, so do revenue, and profit.

In recent quarters, its two main fee sources -- American Capital Mortgage (NASDAQ: MTGE) and American Capital Agency (NASDAQ:AGNC) -- have seen quarter-over-quarter book value erosion, leading to a decline in fee income to American Capital Ltd.

What happened?
American Capital wrote down its asset manager by $185 million in its fiscal fourth quarter. American Capital made new investments in the company during the period, so to remove the effect of that investment, we can reduce its third-quarter valuation of $861 million by $185 million to find that American Capital values it at roughly $676 million.

Putting it in percentage terms, the write down was more than 21% of American Capital Asset Management's (ACAM) value. Interestingly, from quarter-to-quarter, fee income from American Capital Mortgage and American Capital Agency should have declined only about 11% going forward, significantly smaller than the change in the value of ACAM.

American Capital is a bet on mREITs
Last quarter, American Capital executives provided some insight into how it values the asset management arm. In response to an analyst's question, John Erickson, American Capital's CFO, noted that the company's valuation likely included some declines in assets under management and some increases in assets under management much later in the timeline.

This question didn't reappear on the second quarter conference call. We can only expect American Capital is projecting even greater declines in assets under management as its mREITs repurchase more and more shares each quarter, hence the outsized write down at ACAM. Last quarter, American Capital Agency repurchased a full 7% of shares outstanding. 

Between a rock and a hard place
This quarter, some $24 million flowed from ACAM to American Capital in the form of a dividend, equal to 46% of American Capital's total operating income during the quarter. A continued trend of declining assets under management will only continue to strain American Capital's earnings.

This wasn't the quarter American Capital was looking for. Asset management has been its golden division since it was founded, providing quarter-over-quarter improvements as mREITs became a billion-dollar asset class.

This quarter, however, the asset management weakness was just the start of poor performance. Only one of four "arms" of American Capital experienced a write up – its European Capital investment -- and it was only by $115 million -- $70 million short of covering losses at ACAM. We'll know more when it files its annual report, which should be available from the SEC on Friday. 

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