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.
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.