It's crunch time.
American Capital Ltd. (ACAS +0.00%) has been in near-liquidation mode as it seeks to move its existing assets off its own balance sheet to become more of an asset manager than an asset owner.
This week, the company announced a major deal that would allow it to cash out of some of its largest equity investments.
Meet ACE III
American Capital's ACE III is a new private equity fund that will help American Capital Ltd. sell and transfer ownership to new investors. In doing so, American Capital can liquidate some of its investment portfolio and grow the fee generation power of American Capital Asset Management (ACAM), its largest portfolio company. ACAM currently generates the bulk of its fee income from publicly traded mortgage REITs, American Capital Agency (AGNC +0.05%) and American Capital Mortgage (NASDAQ: MTGE), which have been in a slow decline.
ACE III will include $1.1 billion in capital, with the bulk ($0.9 billion), coming from outside investors. American Capital will effectively sell its stakes in seven portfolio companies -- SMG Holdings, CIBT Investment Holdings, FAMS Acquisition, Mirion Technologies, Affordable Care Holdings, PHI Acquisitions, Avalon Laboratories, and WRH -- at a $640 million valuation, assuming the option to buy WRH is exercised.
WRH isn't a guaranteed entrant into the new private equity fund. The buyers have an option to buy WRH, and given its past performance, the option may not be exercised. WRH has been an absolute loser for American Capital, falling in value to $118 million from an original cost basis of $341 million.
Much of the decline in its value happened over 2013, where its fair value reported by American Capital plunged by more than 40%. (Going back as far as the end of 2010, WRH was valued at half its cost basis. This has been a very volatile holding, but it's been down much more than it's been up.)
The overall deal, valued at $640 million, represents a 10% discount to the fair values as of December 31, 2013 ($711 million). A 10% discount for such a large sale is more than fair -- especially since American Capital Ltd. will recoup some of the discount from on-going fees paid to American Capital Asset Management for overseeing ACE III.
Valuing the fee contribution
American Capital's previous ACE private equity funds have delivered excellent fee-generation power from a combination of management and incentive fees. ACE I and ACE II generate 2% management fees with incentive fees up to 30% and 35% of gains, respectively.
At a 2% management fee, ACE III would deliver $18 million in outside fees from investors. According to American Capital, the cost to manage the fund should be in the range of $6 million, overhead it intends to transfer to ACAM from American Capital Ltd. That's a minimum of $12 million per year in additional gross profits to American Capital Asset Management.
The Foolish bottom line
ACE III is good news all the way around. First, it provides evidence that American Capital's reported fair values are consistent with what real buyers are willing to pay. Secondly, it showcases how American Capital can transfer its owned assets off balance sheet while creating a very valuable income stream in the form of management fees. It's a win-win all around.
