Você está na página 1de 21
Specialty Finance – Update October 6, 2010 John Hecht jhecht@jmpsecurities.com (415) 835-3912 American Capital, Ltd. Initiating

Specialty Finance – Update

October 6, 2010

 

John Hecht

jhecht@jmpsecurities.com (415) 835-3912

 

American Capital, Ltd. (1)

Initiating Coverage with a Market Outperform Rating and a $7.50 Price Target

Specialty Finance – Update October 6, 2010 John Hecht jhecht@jmpsecurities.com (415) 835-3912 American Capital, Ltd. Initiating

MARKET OUTPERFORM

ACAS $5.89

Price

$5.89

FY: Dec

2010E

2011E

2012E

Target Price

$7.50

Interest Income (M)

1Q

$164.0A

$140.0

$143.0

52-Wk Range

$2.39 - $6.45

2Q

$151.0A

$139.0

$151.0

Shares Out. (M)

340

3Q

$148.0

$139.0

$158.0

Market Cap. (M)

$2,002.6

4Q

$145.0

$139.0

$165.0

Average Daily Vol. (000)

2,051

FY

$608.0

$558.0

$617.0

Float (M)

337.8

Secular Growth Rate

15%

2010E

2011E

2012E

ROE

9.0%E

Operating EPS

1Q

$0.17A

$0.17

$0.20

 

2Q

$0.14A

$0.18

$0.22

Total Debt (M)

$2,900.0

3Q

$0.16

$0.18

$0.23

Debt/Equity

0.9x

4Q

$0.17

$0.19

$0.24

Book Value/Share

$9.15

FY

$0.64

$0.72

$0.89

Price/Book Value

0.64x

P/E

9.2x

8.2x

6.6x

Dividend/Yield

$0/0%

Previous FY

NE

NE

NE

 

CY

$0.64

$0.72

$0.89

P/E

9.2x

8.2x

6.6x

NC indicates no change to previous estimate. NE indicates no previous estimate. Source: Company reports and JMP Securities

INVESTMENT HIGHLIGHTS

Specialty Finance – Update October 6, 2010 John Hecht jhecht@jmpsecurities.com (415) 835-3912 American Capital, Ltd. Initiating

We are initiating coverage of American Capital, Ltd. (ACAS) with a Market Outperform rating

and a $7.50 12-month price target. ACAS is a publicly traded, internally managed business development company (BDC) that primarily invests senior debt, subordinated debt, and equity components of middle-market companies, with the intent of earning attractive returns for shareholders in the form of both net investment income and capital gains. Given that ACAS has worked through its liquidity issues, we believe that investors will now steer their focus towards credit stability and potential NAV recovery, which we expect to be followed by a dividend recovery.

Credit recovery is key, and we believe a credit recovery is under way. As detailed in this initiation, we are observing trends – including lower non-accrual assets and improving portfolio level credit metrics – that suggest that ACAS is undergoing a credit recovery. We believe this will (i) enable ACAS to recover investment depreciation, which will fuel NAV expansion, and (ii) allow ACAS to redeploy capital into income-generating investments, which will aid earnings growth over time.

NAV recovery to be followed by dividend recovery; we expect ACAS to converge towards peer multiples along the way. As we detail in this note, we are observing trends that suggest that ACAS’ credit pipeline is stabilizing and improving. As a result, we believe there may be substantial upside to NAV, in part due to recovery of unrealized depreciation and in part due to retained earnings as ACAS works through its capital loss carry forward. We believe there is potentially $2.00 of NAV upside, driven by recovery on unrealized depreciation and $1.50 to $2.00 NAV upside, driven by earnings retention associated with the capital loss carry forward, for a total of $3.50 to $4.00 upside. In all, we calculate a >40% potential upside to NAV. Further, according to our earnings potential assessment, we believe that, over the next few years, ACAS has the capacity to pay a dividend equating to a 15%+ annual yield on the current price.

We are initiating operating EPS estimates of $0.64 in CY10, $0.72 in CY11, and $0.89 in CY12. We expect the company to return to dividend distributions in 2Q12, and our estimates are modestly ahead of consensus estimates for all periods.

Valuation. Our $7.50 price target is based upon a few factors. First, it equates to approximately 75% of expected NAV in mid-CY11. This value is similar to BDCs that have worked through liquidity issues recently and/or BDCs that pay a lower-than-peer dividend yield. In addition, our $7.50 price target would equate to a dividend yield of 11% assuming that ACAS achieves our potential EPS target, equating to a 15% discount to the peer group.

FOR DISCLOSURE AND FOOTNOTE INFORMATION, REFER TO THE JMP FACTS AND DISCLOSURES SECTION

VALUATION We assess BDC valuations from a price to net asset value (NAV), price to investment

VALUATION

VALUATION We assess BDC valuations from a price to net asset value (NAV), price to investment

We assess BDC valuations from a price to net asset value (NAV), price to investment income (P/E), and dividend yield perspective.

ACAS trades at a price to book (or net asset value, NAV) multiple of 0.64x and a price to estimated 2010 operating income multiple of 9.2x (the company does not currently pay a dividend, and therefore we cannot evaluate it in a yield basis). By comparison, the broad peer group trades at the following average multiples: 1.1x price-to-book, 11.2x price to 2010 operating earnings, and 10.4% dividend yield. The broad peer group includes BDCs of various sizes with a variety of investment focuses, including debt financing for mid-market businesses and equity investments and/or providers of growth capital.

Where there may be similarities drawn between the comparable peer group in the manner of investments made by these companies and their respective corporate structure, we believe ACAS is unique in the sense that it is a NAV stabilization/recovery story for the next several quarters following its recent debt restructuring, and we expect that a dividend yield-based valuation is 1-2 years off.

ACAS' current NAV is $9.15, and we estimate NAV in mid-CY11 to be $9.84 as the company is currently retaining earnings and has been experiencing unrealized appreciation over the past few quarters. Further, as we highlight in this note, we believe there is approximately $2 of potential recoverable NAV and that ACAS' potential core EPS is $0.80 to $0.88, suggesting the company could pay out an annualized dividend of approximately $0.85 once the company has "earned" and offset its capital loss carry forward.

Our $7.50 price target accounts for a few factors. First, it equates to approximately 75% of expected NAV in mid-CY11 (which excludes the potential recovery of unrealized depreciation). This would be similar to KCAP’s (Kohlberg Capital, KCAP, Market Perform) current valuation, a comparison made relevant in that KCAP recently improved its liquidity position as well. In addition, this compares to MVC’s (MVC Capital, MVC, Market Outperform, $15 PT, discount to NAV) current valuation, a comparison made relevant in that MVC distributes a lower-than-peer dividend and in that MVC has a higher-than-peer percentage of equity investments, similar to ACAS. Finally, our $7.50 price target would equate to a dividend yield of 11% assuming that ACAS achieves our potential EPS target, equating to a 15% discount to the peer group.

VALUATION We assess BDC valuations from a price to net asset value (NAV), price to investment

FIGURE 1: Peer Comparison

 

10/5/10

Price

Market

Operating Income/Share

BV/

Dividend/

Dividend/

Company

Ticker

Price

Rating

Target

Cap

2010E

2011E

Share

Share

Yield

Apollo Investment Corp.

AINV

$10.44

N/R

--

$1,977

$1.02

$1.11

$9.51

$1.12

12.00%

Ares Capital Corp.

ARCC

$15.64

MO

$18.00

$3,025

$1.28

$1.58

$14.11

$1.40

8.95%

BlackRock Kelso Capital Corp.

BKCC

$11.87

N/R

--

$766

$1.14

$1.25

$9.83

$1.12

11.35%

Fifth Street Finance Corp.

FSC

$11.25

N/R

--

$599

$1.50

$1.18

$10.43

$1.14

10.34%

Main Street Capital Corp.

MAIN

$16.33

N/R

--

$291

$1.09

$1.26

$12.21

$1.52

10.18%

Hercules Technology Growth Capital Inc.

HTGC

$10.29

MO

$12.00

$468

$0.85

$1.24

9.80

$1.01

9.82%

Kohlberg Capital Corp.

KCAP

$6.75

MP

--

$152

$0.46

$0.64

9.20

$0.68

10.07%

MVC Capital Inc.

MVC

$13.06

MO

$15.00

$308

$0.34

$0.39

17.35

$0.48

3.68%

PennantPark Investment Corp.

PNNT

$10.82

MO

$12.00

$335

$1.09

$1.13

$10.94

$1.06

9.80%

Prospect Capital Corp.

PSEC

$9.80

N/R

--

$756

$1.11

$1.14

$10.29

$1.33

13.78%

TICC Capital Corp.

TICC

$10.40

N/R

--

$269

$0.89

$0.97

$9.03

$0.65

7.74%

Triangle Capital Corp.

TCAP

$16.01

MP

--

$231

$1.51

$1.71

$11.08

$1.64

10.24%

American Capital Ltd.

ACAS

$5.89

MO

$7.50

$1,929

$0.64

$0.72

$9.15

$0.00

0.00%

 

10/5/10

Market

PE Multiples

Price/

Dividend/

Dividend

Company

Ticker

Price

Cap

2010E

2011E

Book

Share

Yield

Apollo Investment Corp.

AINV

$10.44

N/R

--

$1,977

10.2x

9.4x

1.10x

$1.12

12.00%

Ares Capital Corp.

ARCC

$15.64

MO

$18.00

$3,025

12.2x

9.9x

1.11x

$1.40

8.95%

BlackRock Kelso Capital Corp.

BKCC

$11.87

N/R

--

$766

10.4x

9.5x

1.21x

$1.12

11.35%

Fifth Street Finance Corp.

FSC

$11.25

N/R

--

$599

7.5x

9.6x

1.08x

$1.14

10.34%

Main Street Capital Corp.

MAIN

$16.33

N/R

--

$291

15.0x

12.9x

1.34x

$1.52

10.18%

Hercules Technology Growth Capital Inc.

HTGC

$10.29

MO

$12.00

$468

12.1x

8.3x

1.05x

$1.01

9.82%

Kohlberg Capital Corp.

KCAP

$6.75

MP

--

$152

14.7x

10.5x

0.73x

$0.68

10.07%

MVC Capital Inc.

MVC

$13.06

MO

$15.00

$308

38.4x

NM

0.75x

$0.48

3.68%

PennantPark Investment Corp.

PNNT

$10.82

MO

$12.00

$335

9.9x

9.6x

0.99x

$1.06

9.80%

Prospect Capital Corp.

PSEC

$9.80

N/R

--

$756

8.8x

8.6x

0.95x

$1.33

13.78%

TICC Capital Corp.

TICC

$10.40

N/R

--

$269

11.8x

10.8x

1.15x

$0.65

7.74%

Triangle Capital Corp.

TCAP

$16.01

MP

--

$231

10.6x

9.4x

1.44x

$1.64

10.24%

Mean

MEAN

11.2x

9.9x

1.1x

$1.15

10.39%

Median

MEDIAN

10.6x

9.6x

1.1x

$1.12

10.18%

American Capital Ltd.

ACAS

$5.89

MO

$7.50

$1,929

9.2x

8.2x

0.64x

$

-

0.00%

Source: FactSet and JMP Securities

FIGURE 2: ACAS One-Year Price Chart Source: FactSet Research Systems A NAV RECOVERY STORY, AND WE
FIGURE 2: ACAS One-Year Price Chart Source: FactSet Research Systems A NAV RECOVERY STORY, AND WE

FIGURE 2: ACAS One-Year Price Chart

FIGURE 2: ACAS One-Year Price Chart Source: FactSet Research Systems A NAV RECOVERY STORY, AND WE

Source: FactSet Research Systems

A NAV RECOVERY STORY, AND WE EXPECT THE P/NAV TO CONVERGE TOWARDS THE PEER GROUP OVER TIME

FIGURE 2: ACAS One-Year Price Chart Source: FactSet Research Systems A NAV RECOVERY STORY, AND WE

We are hopeful for a NAV recovery followed by a dividend recovery.

Given that ACAS has worked through its liquidity issues, we believe that investors will now steer their focus towards credit stability and potential NAV recovery. As we detail in this note, we are observing trends that suggest that overall credit conditions are stabilizing/improving while our analysis suggests that ACAS' credit pipeline is stabilizing and potentially improving as well. According to our analysis, ACAS could recover approximately $2 of NAV per share through unrealized appreciation if an economic recovery is, in fact, underway. Further, as highlighted later in this report, we believe that ACAS will have ~$600 mm of capital loss carry forwards to shield income, allowing for $1.50-$2.00 per share of NAV retention.

In addition, we anticipate ACAS repaying an additional $310 mm in constricting debt by year end, which, in our opinion, will reduce covenant restrictions to a point where ACAS can begin to refocus on its core business of engaging in buyouts and assisting with buyout financing (the latter of which will be ACAS' focus going forward. The repayment of debt by the end of CY10 would reduce the amortizing debt to less than $422 mm and would provide ACAS: (i) with the ability to retain 75% of excess cash flow for redeployment, (ii) reduced leverage to a point that leaves ACAS well within debt covenant guidelines, and (iii) a reduction in interest rates on the floating rate and fixed rate secured debt by 100 bps. ACAS has a great deal of experience in buyouts and buyout-financing, and we anticipate this market becoming increasingly active over the next few quarters. Additionally, we believe the market has lost some supply-side capacity as a result of the recession and that the competitive environment is more rational as a result, a factor that we believe will favor long-term participants in the market.

In the end, we believe an investment in ACAS initially represents an opportunity to buy a stock at an attractive price relative to its current NAV, where credit conditions are stabilizing and where recovery of losses and unrealized depreciation is likely to take place. Beyond this, we anticipate that ACAS will begin distributing a dividend, offering an attractive enhancement to potential investment returns over time. Over this time horizon, we anticipate that ACAS’ discount to its peer group will contract.

Credit recovery is key, and we believe a credit recovery is under way.

We are observing trends – including lower non-accrual assets and improving portfolio level credit metrics – that suggest that ACAS is undergoing a credit recovery. We believe this will (i) enable ACAS to recover investment depreciation, which will fuel NAV expansion, and (ii) allow ACAS to redeploy capital into income-generating investments, which will aid earnings growth over time.

As we detail in the section “ACAS Credit Performance Review”, we highlight three factors that give us improving comfort with respect to ACAS credit performance. First, we believe that, through fair market valuation, ACAS has economically accounted for its credit risk. We review the CMBS and CLO portfolios in detail in this report, and we conclude there to be some upside in other areas of ACAS’ investment portfolio based on the current valuation of its assets. Second, we note that ACAS non- accrual loans are 5% lower than they were in 2Q09 and that ACAS has incurred unrealized appreciation over the past four quarters, suggesting that ACAS may be benefiting from an economic recovery. Finally, we note that portfolio level credit metrics are improving, which leads us to believe that ACAS may incur further unrealized appreciation (or recovery of depreciation) and that in-flows to non-accruals will slow. Figure 3 highlights these trends.

FIGURE 3: ACAS Credit Quality Metrics Imply Stabilization in Our View 1Q08A 2Q08A 3Q08A 4Q08A 1Q09A
FIGURE 3: ACAS Credit Quality Metrics Imply Stabilization in Our View 1Q08A 2Q08A 3Q08A 4Q08A 1Q09A

FIGURE 3: ACAS Credit Quality Metrics Imply Stabilization in Our View

 

1Q08A

2Q08A

3Q08A

4Q08A

1Q09A

2Q09A

3Q09A

4Q09A

1Q10A

2Q10A

Mean Net Debt to Valuation EBITDA

N/A

N/A

N/A

 
  • 4.0 4.6

  • 4.2 4.4

   
  • 4.5 4.3

4.3

Total Net Debt to Valuation EBITDA

N/A

N/A

N/A

  • 5.1 5.9

  • 5.3 6.5

  • 5.8 5.5

5.5

Debt to EBITDA

5.9

6.0

6.0

  • 5.9 6.3

  • 5.8 6.0

  • 6.0 5.9

5.9

Interest Coverage

1.9

1.8

1.9

  • 2.0 2.0

    • 2.0 2.1

  • 2.2 2.2

2.3

Debt Service Coverage

1.6

1.8

0.6

  • 1.7 1.7

  • 1.7 1.7

  • 1.8 1.8

1.8

Source: Company reports and JMP Securities

NAV history and potential upside to NAV:

As Figure 4 shows, during the recession, ACAS' NAV contracted nearly 75% due to accumulated unrealized losses and charge-offs (realized losses). The company’s price-to-NAV also declined materially during this period: the average P/NAV has been 1.3x since its IPO and the 2Q10 P/NAV was 0.5x. Further, as we detail in this report, we believe that current book value per share of $9.15 has approximately $2 per share of potential upside, driven by a recovery of a portion of unrealized losses (see Figure 12). In our assessment, we believe there is $681 mm of total recoverable value, much of which is tied to European Capital (ECAS, as discussed later in this report); however, we note that a meaningful portion is related to accruing loans that have been marked down due to FAS 157 and that should pay off at par upon maturity. We also expect the company to be able to retain $1.50-$2.00 per share in earnings through the utilization of its capital loss carry forward.

FIGURE 3: ACAS Credit Quality Metrics Imply Stabilization in Our View 1Q08A 2Q08A 3Q08A 4Q08A 1Q09A

FIGURE 4: ACAS BVPS and Price/Book History

ACAS BVPS and Price/BVPS since 2007 $40.00 2.0x 1.8x $35.00 1.6x $30.00 1.4x $25.00 1.2x $20.00
ACAS BVPS and Price/BVPS since 2007
$40.00
2.0x
1.8x
$35.00
1.6x
$30.00
1.4x
$25.00
1.2x
$20.00
1.0x
0.8x
$15.00
0.6x
$10.00
0.4x
$5.00
0.2x
$0.00
0.0x
1Q07
2Q07
3Q07
4Q07
1Q08
2Q08
3Q08
4Q08
1Q09
2Q09
3Q09
4Q09
1Q10
2Q10
ACAS NAV (Left Axis)
Price to Book Value Per Share (Right Axis)
Book Value Per Share
Price/BVPS

Source: Company reports and JMP Securities

More rational competition and the re-emergence of private equity over time will benefit incumbent operators:

We believe that the recession significantly diminished suppliers of credit to the middle markets, and, as a result, we believe that the competitive framework is improved from the 2004-2007 period. Because of the more rational competitive environment, we believe that risk-adjusted returns are enhanced as leverage is lower, spreads are modestly wider, and lending terms are a bit tighter. Further, we believe that hedge funds and other alternative asset classes have reduced capacity to lend to the middle markets. In addition, a large pool of private equity raised between 2006 and 2008 (~$750 mm) will likely require significant financing to support deals in coming years and should enhance demand for credit. Therefore, we believe demand for credit in the middle markets is slowly returning while the playing field is more rational. We do not expect ACAS be an active lender in this market until it has repaid ~$310 mm of debt as a result of the recent exchange, at which point the restrictive covenants will be eased. We expect that ACAS will be able to pay down this restricting debt with realizations and excess cash from operations in the coming quarters, allowing the company to focus more on its core business of middle market buyout financing.

OTHER INVESTMENT HIGHLIGHTS We believe there is material upside to NAV from both retained earnings and

OTHER INVESTMENT HIGHLIGHTS

OTHER INVESTMENT HIGHLIGHTS We believe there is material upside to NAV from both retained earnings and

We believe there is material upside to NAV from both retained earnings and from the recovery of

unrealized depreciation. As we detail in this initiation report, we believe ACAS has two sources to fuel NAV expansion over the next several quarters: retained earnings, as ACAS utilizes its net capital loss carry forward, and the recovery of unrealized depreciation. In our assessment, ACAS will have ~$600 mm, or $1.50 to $1.75 per share, of capital loss carry forward as the company realizes further losses. This capital loss carry forward shields income, allowing ACAS to retain earnings rather than distribute them, in order to grow its NAV. In addition, according to our analysis, it is possible that ACAS could recognize nearly $2 per share of recovery of unrealized depreciation driven in part by the economic recovery and in part by loan payoffs at par on assets that have a fair value below par. Combined, we calculate that there is $3.50 to $4.00 of potential upside to NAV, which equates to an appealing >40% upside.

Core EPS potential reflects strong dividend potential. According to our forecast, ACAS’ intermediate to late-term quarterly earnings capacity is between $0.18 and $0.20 per share. In addition, we believe there is approximately 10% upside to this earnings capacity in the intermediate term given ACAS’ strategy to redeploy capital into higher yielding assets and to reduce debt levels in order to reduce the average cost of funds. Therefore, while we do not anticipate a dividend payment until late CY11 or CY12, we highlight that the potential dividend of approximately $0.85 per share reflects an annual return of 15% on the current stock price.

Reformatted business focus and restructured balance sheet result in a more stable investment

opportunity. In our opinion, two primary factors accounted for the incremental financial weakness that ACAS experienced during the downturn: higher-than-peer leverage and a higher-than-peer composition of equity investments. Before 2009, ACAS consistently operated with leverage (debt to equity) ratios above 0.7x (versus the peer group, which averaged ~0.6x) providing the company little flexibility to navigate through challenging periods. In addition, ACAS’ portfolio was comprised of 40% equity assets by the end of 2007. The combination of relatively high leverage and high exposure to equity assets (which provide no cash return and typically contract in value before other types of securities during a financially challenging period) resulted in liquidity stress and impaired cash earnings during the downturn. Going forward, ACAS has expressed its intention to operate at 0.6x leverage and to invest in a "substantially higher" proportion of debt versus equity investments in order to de-risk the asset mix. Further, as a result of the debt restructuring, ACAS has limited near-term maturities and is focused on paying down additional debt. We believe the current business strategy will result in a more defensive balance sheet and lower risk going forward.

Attractive value: As noted, ACAS currently trades at 0.64x book value in comparison to 1.1x for the peer group. This discount to book is even more pronounced should ACAS recover some or all of the $2 per share in potential upside from asset recoveries, according to our analysis, and/or should ACAS be able to retain income by utilizing its capital loss carry forward. Further, according to our analysis of core earnings potential, ACAS could pay an annual dividend equating to a 15% yield on the current price once it has utilized its capital loss carry forward.

INVESTMENT RISKS

OTHER INVESTMENT HIGHLIGHTS We believe there is material upside to NAV from both retained earnings and

Credit: We view credit as the most significant risk for all unsecured lenders. While we believe ACAS has an excellent credit culture, the company is making subordinate, unsecured investments in lower middle-market companies. Further, ACAS has significant exposure to structured credit assets including CDOs, CLOs, and CMBS. This type of lending entails a meaningful level of credit risk.

Capital markets dependence: As a consequence of its mandated leverage constraint and dividend payout, ACAS is periodically dependent on the equity markets for growth capital. If the capital markets are not open to ACAS or capital is not available at attractive terms, ACAS’ growth could be curtailed.

Recessionary economic environments: Periods of economic weakness, recession, and/or downturn could have adverse effects on the operations of ACAS’ portfolio companies, which could impact ACAS’ operating performance.

Portfolio composition/concentration: RIC rules require that at least 70% of the value of a BDC's total assets must be comprised of investments in eligible portfolio companies and/or cash and cash equivalents, where eligible portfolio companies are generally defined as U.S.-based privately held or thinly traded public companies. So, while opportunistic investments in distressed debt or equity of

public companies, investments in high yield bonds, debt and equity securities in CLO funds, and international

public companies, investments in high yield bonds, debt and equity securities in CLO funds, and international investments are permissible, these may not exceed 30% of the value of a BDC's total assets. Failure to comply could result in fines and the loss of the BDC/RIC tax treatment.

Competition: We believe ACAS operates in a relatively competitive niche of the middle market and is therefore subject to forces of competition.

Restrictive debt covenants: As a result of ACAS' recent debt restructuring, the company is operating under certain restrictions that limit its ability to engage in certain activities. Until these restrictions are removed, ACAS may have certain competitive disadvantages.

Mark-to-market requirement: As an RIC, ACAS is required to mark its investments to "fair value" on a quarterly basis and recognize the net change in valuation through earnings as an unrealized gain or loss. In our view, this is, at best, an inherently imprecise exercise, as most of ACAS’ investments are in private, middle-market companies for which there exist no directly or indirectly observable inputs.

COMPANY OVERVIEW

public companies, investments in high yield bonds, debt and equity securities in CLO funds, and international

American Capital Ltd. (ACAS) primarily invests senior debt, subordinated debt, and equity in the buyouts of private companies and also directly invests in the debt and equity components of middle- market companies with the intent of earning attractive returns for shareholders in the form of both net investment income and capital gains. Additionally, ACAS historically invested in structured financial products including CLO securities, CDO securities, and CMBS. ACAS' investment focus is on middle- market organizations, defined as companies with enterprise values between $20 mm and $500 mm and EBITDA greater than $4 mm, and ACAS has traditionally focused on manufacturing, services, and distribution companies. Additionally, ACAS has an investment in European Capital, a wholly owned investment fund that invests in debt and equity of middle-market companies located in Europe, and ACAS is also an alternative asset manager with ~$9 BB of third-party capital under management across four private and public funds.

Structurally, ACAS is an internally managed, non-diversified, closed-end investment company that is regulated as a business development company (BDC) and operates as a regulated investment company (RIC) for tax purposes.

ACAS completed its initial public offering (IPO) in 1997. Since inception, ACAS has invested over $31 BB in 522 portfolio companies As of 6/30/10, ACAS’ investment portfolio consisted of over 235 companies across 25 industries at a total investment (at fair value) of $5.7 BB. As of 6/30/10, total assets stood at $6.2 BB, and net asset value (NAV) was $9.15 per share.

RESTRUCTURING, DEBT EXCHANGE, AND LIQUIDITY OVERVIEW

public companies, investments in high yield bonds, debt and equity securities in CLO funds, and international

Restructuring Summary

ACAS’ investment portfolio experienced credit quality issues and diminished in value during the recession, causing ACAS to breach certain debt covenants. In order to cure the restrictive issues associated with its default, ACAS entered into an exchange of its debt on 5/3/10 and completed the restructuring on 6/28/10. In the restructuring, ACAS exchanged $2.3 BB of unsecured debt with $1.3 BB of new secured debt maturing in Dec. 2013 and paid down $1 BB of debt with cash. $528 mm of the new $1.3 BB in debt is non-amortizing debt due in August 2013, while $779 mm of the new debt is amortizing debt. ACAS paid a 2% closing fee on the $1.3 BB of new secured debt, and there is an additional 1% fee on the remaining outstanding balance as of 12/31/11 and 12/31/12. $281 mm of the new debt is floating rate at L+650 bps with a 2% LIBOR floor with the rate being reduced 100 bps if ACAS has less than $1 BB in secured debt outstanding. The remainder is fixed rate debt that costs 8.96%, which also will be reduced by 100 bps if ACAS has less than $1 BB in debt outstanding. In addition, covenants under the new debt restrict ACAS' ability to reinvest excess cash flows and require the company to pay down debt with a portion of proceeds from capital raises.

As a result of the exchange, ACAS is somewhat constrained in its capital deployment but, overall, has the ability to improve operational flexibility as it pays down debt. We expect the company to pay down over $300 mm of additional debt by the end of CY10, which would reduce the amortizing debt to less than $422 mm and which would provide ACAS numerous benefits, including: (i) the ability to retain 75% of excess cash flow for redeployment, (ii) reducing leverage to a point that leaves ACAS well within debt covenant guidelines, and (iii) reducing the interest rates on the floating rate and fixed rate secured debt by 100 bps.

Based upon our expectations for the additional debt pay down by the end of CY10, and

Based upon our expectations for the additional debt pay down by the end of CY10, and in consideration of our forecasts for portfolio repayment rates and portfolio liquidity events, we do not believe that the limitations associated with ACAS' restructured debt impede its near-term strategy meaningfully (or at all). Through discussions with management and review of company presentations, we believe it is the company’s intent to further de-lever the organization to a range of 0.6x debt to equity, similar to other BDCs. Our model contemplates this trend.

Lastly, the exchange pushed out the maturities of ACAS. As shown below in Figure 5, the exchange pushed back the 2009, 2010, and 2011 maturities to 2013 with a small maturity in 2012. Therefore, the extension of maturities should provide ACAS with some flexibility to focus on investments and rebuilding the core business.

Based upon our expectations for the additional debt pay down by the end of CY10, and

FIGURE 5: Effects of ACAS Exchange and Credit Facility Amendments

ACAS Debt Maturities Pre- and Post-Exchange

 

($mms)

12/31/2009

6/30/2010

Fixed rate private secure notes due 12/2013

$

-

$

502

Floating rate private secured notes due 12/2013

$

-

$

277

Fixed rate public secured notes due 12/2013

$

-

$

524

Floating rate public secured notes due 12/2013

$

-

$

4

Unsecured public debt due 10/2012

$

548

$

11

ACAS Business Loan Trust 2004-1 asset securitization

$

170

$

160

ACAS Business Loan Trust 2005-1 asset securitization

$

696

$

629

ACAS Business Loan Trust 2006-1 asset securitization

$

377

$

352

ACAS Business Loan Trust 2007-1 asset securitization

$

294

$

250

ACAS Business Loan Trust 2007-2 asset securitization

$

255

$

215

Unsecured revolving credit facility

$

1,388

$

-

Unsecured private debt due 9/2009

$

84

$

-

Unsecured private debt due 8/2010

$

134

$

-

Unsecured private debt due 2/2011

$

26

$

-

Unsecured private debt due 9/2011

$

95

$

-

Unsecured private debt due 10/2020

$

75

$

-

Total:

$

4,142

$

2,924

Source: Company reports and JMP Securities

ACAS PORTFOLIO OVERVIEW

Based upon our expectations for the additional debt pay down by the end of CY10, and

ACAS seeks to make investments in companies with at least $4 mm in EBITDA in LBO transactions. At 6/30/10, ACAS’ investments totaled approximately $5.7 BB (FMV) and consisted primarily of subordinated debt, senior debt, and preferred equity. The portfolio is diversified by company, industry, and investment structure. The portfolio is comprised of investments in over 235 companies across 25 industries (Figure 6) with the average investment per company ranging between $30 mm and $50 mm, historically equating to ~0.5% of total assets on average. Figure 6 provides an overview of the ACAS investment portfolio by industry as of 6/30/10. We note that no industry comprises more than 12.4% of the portfolio and that ACAS’ average investment has represented only 0.5% of total assets. The portfolio is also diversified geographically with 24% in the Southwest, 19.4% in the Mid-Atlantic, 15.1% in the Northeast, 12.2% in South-Central, 11.4% internationally, 10% in the Southeast, 7.5% in North- Central, and 0.4% in the Northwest.

FIGURE 6: June 2010 Portfolio by Industry Concentration Industry Diversification at Fair Value as of 6/30/10
FIGURE 6: June 2010 Portfolio by Industry Concentration Industry Diversification at Fair Value as of 6/30/10

FIGURE 6: June 2010 Portfolio by Industry Concentration

Industry Diversification at Fair Value as of 6/30/10 Leisure Equipment Other Software 2% Capital Markets 11%
Industry Diversification at Fair Value as of 6/30/10
Leisure Equipment
Other
Software
2%
Capital Markets
11%
2%
Commercial Services
2%
12%
Construction
2%
Diversified Consimer Services
Household Durables
2%
6%
Electrical Equipment
Computers and Peripherals
6%
2%
Food Products
2%
Hotels, Restaurants and Leisure
Electronic Equipment
5%
3%
Building Products
3%
Internet and Catalogue Retail
5%
Diversified Financial Services
IT Services
3%
5%
Pharmaceuticals
Healthcare Providers
Life Science Tools
3%
5%
3%
Auto Components
Professional Services
REIT
Healthcare Equip
Internet Software
4%
3%
3%
3%
4%

Source: Company reports

Figure 7 below provides an overview of ACAS’ investment portfolios by asset type. The portfolio is reflective of ACAS’ historical investment balance among senior debt, subordinated debt, and equity. The portfolio also contains legacy structured investments including investments in CMBS and CLO securities, both of which make up a substantially higher percentage of the portfolio at cost given the material amount of fair market value depreciation that has occurred in these securities. As of 6/30/10, the yield on ACAS’ Private Finance Debt was 10.3%, up from 9.9% as of 12/31/09.

FIGURE 6: June 2010 Portfolio by Industry Concentration Industry Diversification at Fair Value as of 6/30/10

FIGURE 7: Portfolio Breakdown by Investment Type as of 6/30/10 at Fair Value

ACAS Investment by Security Type as of 6/30/10

Revolving Credit Facility

Warrants 2% CLO 1% CMBS 23% 7% Equity in Managed Funds 1% 5% Common Senior>L+650 Senior<L+650
Warrants
2%
CLO
1%
CMBS
23%
7%
Equity in Managed Funds
1%
5%
Common
Senior>L+650
Senior<L+650
Preferred
6%
19%
2%

Subordinated Debt

34%

Source: Company reports and JMP Securities

Figure 8 below provides an overview of the cost and fair value within the ACAS portfolio by investment type. We note that structured product investments have experienced the most significant fair value depreciation within the portfolio in terms of percentages but that control investments reflect the largest losses on a dollar basis.

FIGURE 8: Cost vs. Value by Investment Type for ACAS Portfolio as of 6/30/10 Fair Market
FIGURE 8: Cost vs. Value by Investment Type for ACAS Portfolio as of 6/30/10 Fair Market

FIGURE 8: Cost vs. Value by Investment Type for ACAS Portfolio as of 6/30/10

 

Fair Market

Investment Type

Cost

Value

Gain/(loss)

% Gain/(loss)

Investments in Non-controlled, non-affiliated portfolio companies

$3,764

$2,888

-$876

-23.3%

CMBS Investments

$413

$30

-$383

-92.8%

CLO Investments

$233

$117

-$116

-49.7%

Affiliate Investments

$300

$216

-$84

-28.0%

Control Investments

$3,730

$2,443

-$1,287

-34.5%

Total Portfolio

$8,439

$5,694

-$2,745

-32.5%

Source: Company reports and JMP Securities

CMBS securities: Through discussions with management and based upon discussions with industry participants, we believe that the 93% depreciation on CMBS investments is reasonable if not conservative. We believe that many of these investments will continue to be impaired from a cash flow perspective, and, given the overall impaired state of liquidity in the market, we do not anticipate much upside in the current environment. That said we do not believe the CMBS securities pose a meaningful threat to book value given what we believe to be sufficient markdown as shown in Figure 8 above.

CLO securities: Figure 9 below provides a comparison of ACAS' valuations of its CLO investments (shown above in Figure 8 as well) versus an Intex model-based pricing of each security. We note overall that the portfolio appears fairly valued, with the sum of the Intex modeled portfolio yielding a cumulative value within 1% of the current fair market value of these securities as presented on ACAS’ balance sheet. We note that there could be some discrepancies in our analysis based on the respective tranche of the security (which we do not know), and, for our Intex run, we assumed the lowest tranche out of conservatism. In addition, we assumed the following: future defaults: 3%; recoveries: 65%; dollar price for reinvested assets: 98; LIBOR margin for reinvested assets: 400 bps; assumed IRR on CLO debt securities: 15%; assumed IRR on CLO equity securities: 30%. Given our analysis, we feel that the CLO investments do not pose much risk or provide meaningful upside to ACAS' NAV.

FIGURE 8: Cost vs. Value by Investment Type for ACAS Portfolio as of 6/30/10 Fair Market

FIGURE 9: ACAS CLO Portfolio Valuation versus Intex

CLO Investments

Asset Class

Intex Generated Price as of % of Cost

ACAS Price as of % of Cost

ACAS CLO 2007-1, Ltd.

Secured Notes

57.5%

51.2%

57.7%

74.8%

ACAS CLO 2007-1, Ltd.

Subordinate Notes

49.6%

39.3%

Ares IIIR/IVR CLO Ltd.

Subordinated Notes

33.8%

35.4%

Ares VIII CLO, Ltd.

Preference Shares

52.5%

92.9%

Avalon Capital Ltd. 3

Preferred Securities

56.2%

73.9%

Babson CLO Ltd. 2006-II

Income Notes

57.7%

62.5%

BALLYROCK CLO 2006-2 LTD.

Deferrable Notes

68.5%

80.2%

Cent CDO 12 Limited

Income Notes

77.4%

86.2%

Centurion CDO 8 Limited

Subordinated Notes

52.4%

57.1%

Champlain CLO

Preferred Securities

9.4%

6.0%

CoLTs 2005-1 Ltd.

Preference Shares

59.1%

32.0%

CoLTs 2005-2 Ltd.

Preference Shares

2.3%

16.7%

CREST Exeter Street Solar 2004-2

Preferred Securities

24.6%

21.2%

Eaton Vance CDO X PLC(3)

Secured Subordinated Income Notes

39.4%

87.0%

Essex Park CDO Ltd.

Preferred Securities

62.0%

69.2%

Flagship CLO V

Deferrable Notes

41.7%

59.5%

Flagship CLO V

Subordinated Notes

17.6%

13.0%

Galaxy III CLO, Ltd

Subordinated Notes

33.9%

21.6%

LightPoint CLO IV, LTD

Income Notes

59.7%

70.6%

LightPoint CLO VII, Ltd.

Subordinated Notes

73.3%

59.1%

LightPoint CLO VIII, Ltd.

Deferrable Notes

51.8%

43.7%

Mayport CLO Ltd.

Income Notes

59.2%

75.0%

NYLIM Flatiron CLO 2006-1 LTD.

Subordinated Securities

40.3%

83.3%

Octagon Investment Partners VII, Ltd.

Preferred Securities

29.1%

11.0%

Sapphire Valley CDO I, Ltd. Vitesse CLO, Ltd.

Subordinated Notes Preferred Securities

56.4%

54.2%

Source: Intex, company reports, and JMP Securities

MANAGED FUNDS OVERVIEW ACAS had ~$15 BB in capital resources under management as of 6/30/10, including

MANAGED FUNDS OVERVIEW

MANAGED FUNDS OVERVIEW ACAS had ~$15 BB in capital resources under management as of 6/30/10, including

ACAS had ~$15 BB in capital resources under management as of 6/30/10, including $7.8 BB under American Capital Agency. Figure 10 below outline ACAS’ 3 rd party asset managers. We note that ACAS had $5.7 BB of investments on its balance sheet as of 6/30/10 including the investment in ECAS (which is detailed below).

MANAGED FUNDS OVERVIEW ACAS had ~$15 BB in capital resources under management as of 6/30/10, including

FIGURE 10: ACAS Managed Funds

MANAGED FUNDS OVERVIEW ACAS had ~$15 BB in capital resources under management as of 6/30/10, including

Source: Company reports and JMP Securities

American Capital Agency (AGNC, Market Perform): Established in 2008 and publicly listed on Nasdaq, AGNC is a mortgage REIT that invests exclusively in agency securities and collateralized mortgage obligations for which the principal and interest payments are guaranteed by a U.S. government agency or a U.S. government-sponsored entity. AGNC is externally managed and advised by American Capital Agency Management, LLC, a subsidiary of a wholly-owned portfolio company of ACAS. As of 6/30/10, ACAS held a common member interest in AGNC equating to $50 mm at cost, $66.1 mm at fair value, and representing 1.16% of ACAS' investments at fair value.

Private Equity Managed Funds: In 2007, ACAS initiated a strategy to reduce its own equity exposure by raising off balance sheet private equity funds that, in turn, would purchase strips of equity from ACAS’ investment portfolio. Through these funds, ACAS was able to monetize a portion of its equity investments, and would redeploy the proceeds from the sale of equity securities into higher yielding fixed income securities. In addition, ACAS received management fees of 2% of the assets in each fund and maintained 20% of the performance-oriented upside in the funds. ACAS established ACE 1 (American Capital Equity I) in October 2006 as a $1 billion private equity fund managed by American Capital, and this fund subsequently purchased 30% of American Capital’s equity interest in 96 portfolio companies. ACE 2 (American Capital Equity II) was established in October 2007 as a $585 million private equity fund managed by American Capital, which purchased 17% of American Capital’s equity investments in 80 portfolio companies. As of 6/30/10, ACAS reflected its portion of ACE I and ACE II on its balance sheets equating to $70.8 mm at cost, $65.9 mm at fair value, and representing 1.16% of ACAS' investments at fair value.

European Capital (ECAS) is an investment company for pan-European equity, mezzanine, and senior debt investments with capital resources of approximately €2.7 billion ($3.5 billion). It is managed by a wholly-owned affiliate of ACAS. ECAS invests in private and public companies headquartered predominantly in Europe, investing typically between €5 million and €25 million per transaction in equity, mezzanine debt, and senior debt. ACAS has been an investor in ECAS since 2008, and, as of 6/30/10, ACAS held subordinated debt in ECAS of $53.7 mm at cost and $53.9 mm at fair value and equity in ECAS of $1,267.3 mm at cost and $409 mm at fair value. The current fair value of ECAS equity represents a ~$300 mm discount to ECAS’s NAV of ~$700 mm due to public comparable companies in Europe and restricted liquidity. Combined, the investments in ECAS represent 8.13% of the ACAS portfolio at fair market value.

CDO/CLO Group: ACAS also employs a CDO/CLO asset manager. The group originates and manages a portfolio of principal investments in CDOs and CLOs. As of 6/30/10, the CLO and CDO investments were held as a portion of non-control, non-affiliate investments, and the CLO portfolio

reflected a total value of $117 mm versus a total cost of $233 mm; the CMBS

reflected a total value of $117 mm versus a total cost of $233 mm; the CMBS portfolio reflected a total value of $30 mm versus a total cost of $413 mm.

ACAS' INTERMEDIATE-TERM STRATEGY

reflected a total value of $117 mm versus a total cost of $233 mm; the CMBS

Further delevering and risk reduction

Following the restructuring, ACAS is primarily focused on delevering further and reducing the risk on its balance sheet. As discussed, ACAS intends to pay down secured debt by $310 mm by year end. This would further delever the balance sheet and would reduce total leverage to less than 0.8x. Additionally, this action would reduce the interest rates by 100 bps on the debt issued through the recent exchange, and would provide ACAS the ability to redeploy up to 75% of its free cash flow (versus the 50% it currently has the ability to redeploy). ACAS intends to reduce its leverage to 0.6x over time, and intends to use on-balance securitizations in order to finance the portfolio going forward.

Redeploy capital into higher yielding fixed income securities

ACAS' portfolio entering the recession was heavily weighted with equity securities in comparison to peers. At CYE 2007, ACAS' portfolio was composed of 54% debt, 40% equity, and 6% structured products. In addition to delevering, we believe that ACAS is also focused on reducing the equity composition within its portfolio in order to mitigate credit risk. Further, as ACAS liquidates equity investments, we expect the company will redeploy the proceeds into fixed income securities, particularly mezzanine securities, in order to boost investment income. ACAS will likely continue to invest in equity, but at a smaller volume than debt securities and primarily in existing portfolio companies. Additionally, we note that ACAS intends to hold certain equity investments through the economic recovery in order to benefit from potential EBITDA growth and multiple expansion.

Raising additional managed funds to further reduce equity exposure

To further reduce the overall equity composition of the portfolio, ACAS will attempt to raise new managed funds for private equity investments, similar to ACE 1 and ACE 2. As previously discussed, ACAS will use these funds to monetize equity investments on its balance sheet (in order to redeploy these into fixed income securities). ACAS receives a 2% management fee and maintains a portion of the economic upside in the remaining equity investments.

ASSESSMENT OF CORE EARNINGS POTENTIAL

reflected a total value of $117 mm versus a total cost of $233 mm; the CMBS

Figure 11 below highlights ACAS' core potential for the intermediate term if the aforementioned strategies are successfully implemented. In our analysis, we include the effects of further delevering and the impact on interest expense. We calculate ~$20 mm in interest expense savings annually if ACAS delevers according to our calculations (targeting 0.6x leverage by mid-CY11) and benefits from a 100 bps reduction in the cost of funds. Second, we estimate that ACAS will monetize 30% of its equity and preferred equity investments ($342 mm outstanding as of 6/30/10), reinvesting 75% of these proceeds (per the debt covenants) into mezzanine debt. We assume a 12% yield on mezzanine investments, which is lower than current market rates. According to our analysis, potential core EPS at ACAS is $0.20 to $0.22 per quarter, up from $0.18-$0.20 currently. Figure 11 highlights this analysis.

reflected a total value of $117 mm versus a total cost of $233 mm; the CMBS

FIGURE 11: ACAS Potential Core EPS Upside

ACAS Potential Core EPS

 

$ MM of Earnings Augment

 

EPS

Current Quarterly Core Earnings per Share

$

0.18-$0.20

+ Reduced interest expense (100 bps) and lower leverage

$

20

+ Sale of 30% of equity investments and 75% (debt covenants) invested into Mezz debt

$

4

+ Sale of 30% of preferred equity investments and 75% (debt covenants) invested into Mezz debt

$

10

Additions to Earnings

$

34

Est. Shares outsanding CYE 2011

340

Potential additional EPS, quarterly

$0.02

Total potential core quarterly EPS

$

0.20-$0.22

Source: Company reports and JMP Securities

We note that there are significant obstacles facing ACAS that it must overcome to increase its core EPS. Disposing of equity through asset sales or the raising of an additional equity fund could be difficult. Further, ACAS' lowest cost debt is in its securitizations, and, as these pay down, it could result in a rising average cost of funds. Lastly, our analysis depends upon ACAS’ ability to originate mezzanine investments, which may not come to fruition.

POTENTIAL NAV RECOVERY / UPSIDE TO ACAS BOOK VALUE In order to assess potential upside to

POTENTIAL NAV RECOVERY / UPSIDE TO ACAS BOOK VALUE

POTENTIAL NAV RECOVERY / UPSIDE TO ACAS BOOK VALUE In order to assess potential upside to

In order to assess potential upside to NAV (or NAV recovery), we assume that ACAS recovers some of its unrealized depreciation as the economy improves. Figure 12 below outlines our assumptions for potential recoveries to NAV. As shown, we estimate that accruing debt will experience a 75% recovery rate (meaning that ACAS will recover 75% of its fair value depreciation on this asset class), a 45% recovery on the remaining senior loans, and a 15% recovery on subordinate loans. In addition, we estimate that ACAS will recover 45% of its markdown on ECAS' equity, 10% of its preferred stock markdown, and 8% on both equity and warrant markdowns. Our recovery analysis for loans is based on recoveries we have seen in the high yield and middle-market loan markets for other BDCs, while our equity recovery assumptions are more speculative in nature given that we have not seen other recoveries in this asset class yet. That said, we feel our equity recovery estimates are conservative given they represent ~11% of our total NAV recovery. We do not anticipate recoveries on CMBS or on CLOs given that we view these marks as appropriately conservative but not offering significant upside. Figure 12 outlines our analysis, and, according to our calculations, ACAS has approximately $2 per share in book value recovery, or approximately 22% upside to current NAV.

POTENTIAL NAV RECOVERY / UPSIDE TO ACAS BOOK VALUE In order to assess potential upside to

FIGURE 12: Potential Upside to ACAS NAV through Recovery of Unrealized Depreciation

 

ACAS Potential NAV Appreciation (mm's)

 
 

Unrealized Depreciation as of 6/30/10

Recovery %

Effect on NAV

NAV per Share as of 6/30/10

$9.15

75% Recovery of Accruing Loans

($153)

75%

$114.8

45% Recovery on Other Senior Loans*

($154)

45%

$69.3

45% Recovery on ECAS Equity*

($859)

45%

$386.3

15% Recovery on Subordinated Loans*

($225)

15%

$33.8

10% Recovery on Preferred Stock*

($490)

10.0%

$49.0

8% Recovery on Common Stock*

($342)

8%

$27.3

5% Recovery on Warrants*

($22)

5%

$1.1

Total

($2,244)

30.4%

$681.51

Shares Outstanding

 

340

Total Upside to NAV per share

$2.00

Total Potential NAV per share

 

$11.15

Source: Company reports and JMP Securities

DIVIDEND OVERVIEW & NET CAPITAL LOSS CARRY FORWARD ANALYSIS

POTENTIAL NAV RECOVERY / UPSIDE TO ACAS BOOK VALUE In order to assess potential upside to

In accordance with RIC rules, ACAS must distribute a minimum of 90% of its net investment income plus net capital gains for any given taxable year. ACAS has not declared a dividend since 2Q09 given losses and RIC and debt restrictions. We note that, as of 6/30/10, ACAS had an asset coverage ratio of 206% and therefore had no dividend restrictions based upon RIC considerations or under its debt agreements.

That said, we believe that ACAS will have a capital loss carry forward of ~$600 mm as of its tax year, which can be used to shield investment income and investment gains going forward. Therefore, ACAS is in a unique position in which it does not have to distribute RIC earnings in the form of dividends until it has exhausted the tax shield from its capital loss carry forward. The net capital loss carry forward may be carried for eight years. According to our model, we are forecasting for ACAS to make ~$600 mm in core earnings between now and approximately 2012 and therefore believe that ACAS will not have to pay any taxes and / or dividends until late CY11 or early CY12. However, given that we do not forecast for realized gains, it is possible that, as a result of unanticipated gains, ACAS will have to pay a dividend before this period. Therefore, we anticipate that ACAS will begin paying dividends in early CY12, which could be accelerated if the portfolio performs well. In all, according to our calculations we believe that ACAS can shield $1.50-$2.00 of income per share with the capital loss carry forward equating to 15%- 22% of NAV appreciation. As discussed, we believe ACAS will have the capacity to pay a $0.80-$0.85 dividend per share in 2012, equating to a 16% dividend yield at the current price.

As an aside, the IRS is permitting ACAS to follow the 90:10 stock cash dividends rule for dividend payments through 2011. Therefore, ACAS can pay dividends with 90% stock and 10% cash through its 2011 tax year, although we do not forecast for dividends during this period.

ACAS CREDIT PERFORMANCE OVERVIEW ACAS experienced significant realized and unrealized losses throughout the recession in part

ACAS CREDIT PERFORMANCE OVERVIEW

ACAS CREDIT PERFORMANCE OVERVIEW ACAS experienced significant realized and unrealized losses throughout the recession in part

ACAS experienced significant realized and unrealized losses throughout the recession in part due to its equity and preferred equity exposure and in part due to the fact that ACAS was very active in originating investments during 2006 and 2007 when the risk of loss was increasing. Figure 13 below highlights ACAS' portfolio by security type and further breaks down the cost versus fair market value for these investments. We note that preferred stock and equity write downs account for nearly 30% of the portfolio depreciation, not including ACAS' investment in ECAS, which alone represents over 31% of the unrealized loss. Additionally, we note that ACAS' investments in CMBS represent 14% of the losses. As we discussed, at CYE 2007, ACAS' portfolio was composed of 54% debt, 40% equity, and 6% structured products, and, as the economy entered into a downturn, ACAS was more susceptible to losses relative to peer BDCs that had less exposure to non-debt securities.

ACAS CREDIT PERFORMANCE OVERVIEW ACAS experienced significant realized and unrealized losses throughout the recession in part

FIGURE 13: ACAS Fair Value Marks by Asset Class ($ mms)

 

Fair Market

% of Portfolio

 

Investment Type

Cost

Value

Gain/(loss)

% Gain/(loss)

Gain/(loss)

Warrants

$93

$71

-$22

-23.5%

0.8%

Subordinated debt

$2,157

$1,932

-$225

-10.4%

8.2%

Senior debt

$1,995

$1,688

-$307

-15.4%

11.2%

Preferred stock

$1,574

$1,085

-$490

-31.1%

17.8%

Common stock (ex ECAS)

$701

$359

-$342

-48.8%

12.4%

CMBS

$413

$30

-$383

-92.8%

13.9%

CLO

$233

$117

-$116

-49.7%

4.2%

ECAS (Equity)

$1,267

$409

-$859

-67.7%

31.3%

Total Portfolio

$8,439

$5,694

-$2,745

-32.5%

100.0%

Source: Company reports and JMP Securities

While the peer group average of non-accrual assets to total assets has been in the mid to high single digits (as a % of cost), we note that ACAS’ equivalent level of non-accrual assets has been in the mid- teens. As a result of impairments on its investments, ACAS breached the 1:1 BDC leverage test, and a series of events eventually led to the debt exchange in 2Q10 to avoid bankruptcy. Figure 14 below provides an overview of ACAS' non-accruals through the recession with the graph representing the % of non-accruals to total loans and the actual dollar amounts in the table below. We note that credit trends appear to be stabilizing but that ACAS is clearly still working through its credit problems with a meaningful portion of its portfolio remaining on non-accrual or past due. Additionally, 2Q10 marked a modest uptick in non-accruals after three quarters of generally improving credit.

ACAS CREDIT PERFORMANCE OVERVIEW ACAS experienced significant realized and unrealized losses throughout the recession in part

FIGURE 14: ACAS Non-Accrual and Past Due Loans

Non-Accrual Loans Past Due for ACAS Since 1Q08

2Q09A Non-accrual loans at FV as a % of total loans Past due and non-accrual loans
2Q09A
Non-accrual loans at FV as a % of total loans
Past due and non-accrual loans at cost as a % of total loans
1Q08A
1Q10A
1Q09A
3Q09A
3Q08A
2Q10A
25.0%
2Q08A
4Q08A
4Q09A
0.0%
5.0%
10.0%
15.0%
20.0%
 

1Q08A

2Q08A

3Q08A

4Q08A

1Q09A

2Q09A

3Q09A

4Q09A

1Q10A

2Q10A

Loans on non-accrual at cost

$375

$481

$602

$871

$1,103

$1,025

$912

$811

$671

$686

Loans on non-accrual at FV

$80

$116

$135

$150

$214

$310

$285

$290

$263

$308

Past due loans at cost

$106

$42

$80

$50

$41

$45

$209

$88

$47

$57

Past due and non-accrual loans at cost as a % of total loans

8.2%

8.6%

10.7%

14.5%

18.1%

19.4%

21.5%

18.1%

15.4%

16.5%

Non-accrual loans at FV as a % of total loans

1.5%

2.1%

2.4%

2.9%

4.4%

7.2%

6.9%

7.8%

7.0%

8.5%

Source: Company reports and JMP Securities

While non-accruals appear to be stabilizing at ACAS, as Figure 15 shows, other elements of ACAS'

While non-accruals appear to be stabilizing at ACAS, as Figure 15 shows, other elements of ACAS' private finance portfolio also appear to be improving, with overall debt to EBITDA levels declining overall since mid-2009 and with the average interest coverage ratios improving as well. We note that the overall improvement of the credit statistics may imply that in-flows to non-accruals should slow. Additionally, the enhanced portfolio quality could likely lead to some recoveries of unrealized appreciation as we previously analyzed.

While non-accruals appear to be stabilizing at ACAS, as Figure 15 shows, other elements of ACAS'

FIGURE 15: ACAS Credit Quality Metrics Imply Stabilization, in Our View

 

1Q08A

2Q08A

3Q08A

4Q08A

1Q09A

2Q09A

3Q09A

4Q09A

1Q10A

2Q10A

Mean Net Debt to Valuation EBITDA

N/A

N/A

N/A

4.0

4.2

4.4

4.6

 
  • 4.5 4.3

4.3

 

Total Net Debt to Valuation EBITDA

N/A

N/A

N/A

5.1

5.3

6.5

5.9

  • 5.8 5.5

5.5

Debt to EBITDA

5.9

  • 6.0 6.0

5.9

5.8

6.0

6.3

  • 6.0 5.9

5.9

Interest Coverage

1.9

  • 1.8 1.9

2.0

2.0

2.1

2.0

  • 2.2 2.3

2.2

Debt Service Coverage

1.6

  • 1.8 0.6

1.7

1.7

1.7

1.7

  • 1.8 1.8

1.8

Source: Company reports and JMP Securities

Lastly, we look at cumulative unrealized gains and losses and compare and contrast this with the peer group. Figure 16 highlights ACAS' cumulative realized and unrealized gains and losses. Since 1Q08, ACAS has experienced significant realized and unrealized losses in its portfolio. Figure 16 exhibits a general positive trend in the portfolio since late CY09. The cumulative unrealized losses are shrinking as a percentage of total investments at cost, and we expect future realized loss events to slow in the future as a result. From the figure, we believe ACAS is working through its peak charge off period and will be emerging from this phase in the near term.

While non-accruals appear to be stabilizing at ACAS, as Figure 15 shows, other elements of ACAS'

FIGURE 16: ACAS Realized and Unrealized Gains/Losses

-60.0% -10.0% -20.0% -30.0% -40.0% -50.0% 1Q08A 10.0% 0.0%
-60.0%
-10.0%
-20.0%
-30.0%
-40.0%
-50.0%
1Q08A
10.0%
0.0%
-60.0% -10.0% -20.0% -30.0% -40.0% -50.0% 1Q08A 10.0% 0.0%
1Q09A 1Q10A FY09A 4Q09A 3Q09A 2Q09A FY08A 4Q08A 3Q08A 2Q08A ACAS Cumulative Realized and Unrealized Losses
1Q09A
1Q10A
FY09A
4Q09A
3Q09A
2Q09A
FY08A
4Q08A
3Q08A
2Q08A
ACAS Cumulative Realized and Unrealized Losses as % of Average Investments at
Cost

Cum Real. Losses as % Avg Investments (Cost)

Cum FV Marks as % of Avg Investments (Cost)

Cum Real. Losses as % Avg Investments (Cost) Cum FV Marks as % of Avg Investments
1Q09A 1Q10A FY09A 4Q09A 3Q09A 2Q09A FY08A 4Q08A 3Q08A 2Q08A ACAS Cumulative Realized and Unrealized Losses

Source: Company reports and JMP Securities

MANAGEMENT

While non-accruals appear to be stabilizing at ACAS, as Figure 15 shows, other elements of ACAS'

Malon Wilkus, Chairman and CEO: Malon Wilkus founded American Capital, Ltd. in 1986 and has served as its Chief Executive Officer and Chairman of the Board of Directors since that time, except for the period from 1997 to 1998 during which he served as Chief Executive Officer and Vice Chairman of the Board of Directors. He also served as President of the company from 2001 to 2008 and from 1986 to 1999. In addition, Mr. Wilkus is the President of American Capital, LLC, ACAS’ fund management portfolio company. He is also Chief Executive Officer, President, and Chairman of the Board of Directors of American Capital Agency Corp.

John R. Erickson, President, Structured Finance and CFO: John R. Erickson has served as the President, Structured Finance of American Capital, Ltd. since 2008 and as its Chief Financial Officer since 1998. He also served as Secretary of the company from 1999 to 2005 and an Executive Vice President from 2001 to 2008. From 1998 to 2001, Mr. Erickson was a Vice President.

Gordon O'Brien, President, Structured Finance and Operations: Gordon O'Brien joined American Capital in October 1998. In

Gordon O'Brien, President, Structured Finance and Operations: Gordon O'Brien joined American Capital in October 1998. In July 2008 he was named to his current position. From 1995 to 1998, Mr. O'Brien was Vice President at Pennington Partners & Company, a private equity firm where Mr. O'Brien was responsible for structuring private equity investments, conducting due diligence, negotiating debt agreements, and managing portfolio companies. Prior to his tenure at Pennington Partners, Mr. O'Brien worked at Golder, Thoma, Cressey, Rauner, Inc., a private equity firm, and before that at Chemical Bank in Chicago. Mr. O'Brien holds a graduate degree in business from the University of Chicago and an undergraduate degree from the University of Pennsylvania, Wharton School of Business.

Ira Wagner, President, European Private Finance: Ira Wagner initially joined American Capital Ltd. in 1986 and rejoined in October 1997 as a Principal. In August 2008 he became President, European Private Finance. He led the development of American Capital’s European private finance platform beginning in 2004, being named President of European Capital Financial Services in 2005. In addition, Mr. Wagner led the development of American Capital’s Syndications Team in New York beginning in 2005, which is responsible for placing senior debt underwritten by American Capital. Prior to earning his M.B.A. at the University of North Carolina at Chapel Hill in 1985, Mr. Wagner was the co-founder of a business distributing imported auto parts in western New England from 1975 through 1982.

Brian Graff, Senior Managing Director: Mr. Graff has served as a Senior Vice President since 2004 and as a Senior Managing Director since 2008. From 2005 to 2008 he served as a Regional Managing Director and from 2004 to 2005 he served as a Managing Director. Mr. Graff also served as a Vice President and Principal from 2001 to 2004. From 2000 to 2001, he was a Principal of Odyssey Investments Partners, a private equity fund. Mr. Graff holds a B.S. degree in Accounting from the State University of New York at Binghamton and an M.B.A. from NYU's Stern School of Business.

Darin Winn, Senior Managing Director: Darin Winn joined American Capital in August 1998 as a Principal opening the Dallas office, was promoted to Managing Director in 2001, became a member of the Investment Committee in 2002 and was promoted to Regional Managing Director in 2005 and then to Senior Managing Director in 2008. Mr. Winn leads the Dallas office with a team of eleven investment professionals; that team is responsible for managing a portfolio of thirteen investments comprising approximately $285 million in assets. Prior to joining American Capital, from 1995 to 1998 Mr. Winn was with Stratford Capital Partners, a $130 million mezzanine and equity fund controlled by Hicks, Muse, Tate & Furst. While with Stratford. Mr. Winn holds a Bachelor of Business Administration in Finance from the University of Texas at Austin.

OUR MODEL

Gordon O'Brien, President, Structured Finance and Operations: Gordon O'Brien joined American Capital in October 1998. In

Our focus is on net investment income, the individual components of which generally are recurring in nature. As a note, we do not include a forecast for realized gains and/or losses in our models as there generally is little or no visibility into this component of a BDC’s operations. And while we acknowledge that fair value adjustments are a quarterly reality for all BDCs, we also do not include a forecast for unrealized gains and/or losses in our models given that most of a BDC’s investments are in private companies for which there exists no publicly available market price/quotation.

While the recovering capital and credit markets appear to be generating a strong flow of potentially attractive investment opportunities, ACAS remains partially constrained in investing, and we highlight the near-term benefits of continued de-levering. We are currently modeling for a period of net portfolio run-off until ACAS has paid down additional debt before we expect portfolio begin to grow again in 2012. We are modeling modest balance sheet growth in 2012.

In terms of all-in investment yields, including interest, fees, dividends, and other income, we anticipate some yield expansion due to increasing spreads in the coming quarters, and we would expect this to continue through 2011 and 2012. Although the capital and credit markets have experienced significant tightening in terms of spreads, the middle market has not rallied to the same extent as the high yield or high grade credit market, and therefore we do anticipate modest earning asset yield growth in our model.

With that, when we fold our assumptions into our earnings model, we arrive at FY10, FY11, and FY12 net investment income per share estimates of $0.67, $0.78, and $1.02, respectively. Additionally, we are anticipating that ACAS resumes paying a dividend in 2Q12, and we forecast a CY12 dividend of $0.60 per share, beginning in 2Q12 and reflecting $0.20 per quarter. We will monitor ACAS' progress in terms of following its strategy, which could affect how quickly the company is able to return to paying a

dividend again. Figure 17 below provides an overview of our assumptions for our 2010, 2011, and

dividend again. Figure 17 below provides an overview of our assumptions for our 2010, 2011, and 2012 results.

dividend again. Figure 17 below provides an overview of our assumptions for our 2010, 2011, and

FIGURE 17: Model Overview

 

Model Summary (000s)

 

2010Y/E

2011Y/E

2012Y/E

Total Investments

$5,279

$5,005

$5,872

Debt

$2,389

$1,708

$2,513

Stockholders' Equity

$3,225

$3,471

$3,570

Debt/Equity

0.7x

0.5x

0.7x

BDC Debt/Equity

0.7x

0.5x

0.7x

Earning Asset Yield

10.82%

11.12%

11.42%

Cost of Funds

5.82%

5.42%

5.02%

Total Investment Income

$607

$553

$608

Total Expenses

$402

$313

$314

NII per Share - Core EPS

$0.64

$0.72

$0.89

Dividends per Share

$0.00

$0.00

$0.60

Book Value per Share

$9.49

$10.21

$10.49

Source: Company reports and JMP Securities

17

17 FIGURE 18: ACAS Earnings Model American Capital, Ltd (ACAS) 2009 Actual 2010 Estimates 2011 Estimates

FIGURE 18: ACAS Earnings Model

American Capital, Ltd (ACAS)

                 
 

2009 Actual

2010 Estimates

 

2011 Estimates

   

2012 Estimates

 

Yr-End: December 31 ($mms)

FY08A

1Q09A

2Q09A

3Q09A

4Q09A

FY09A

1Q10A

2Q10A

3Q10E

4Q10E

FY10E

1Q11E

2Q11E

3Q11E

4Q11E

FY11E

1Q12E

2Q12E

3Q12E

4Q12E

FY11E

Income statement ($000s)

     

INVESTMENT INCOME

Interest and dividend income

Non-controlled/non-affiliate investments

597

124

71

110

83

388

93

74

71

70

308

69

69

69

69

277

72

76

79

83

309

39

9

13

14

11

47

8

7

7

7

29

6

6

6

6

26

7

7

7

7

28

Affiliate investments

314

46

43

52

62

  • 203 57

49

57

56

219

53

51

50

50

203

51

53

55

57

216

Control investments Interest and dividend income

950

179

127

176

156

  • 638 133

150

138

136

557

129

127

127

127

510

130

137

144

151

561

Asset management and other fee income

     

Non-controlled/non-affiliate investments

35

4

4

9

4

21

4

4

4

4

15

4

4

4

4

15

4

4

5

5

18

1

0

0

0

1

1

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

Affiliate investments

65

12

9

8

8

  • 37 9

10

9

9

36

8

8

8

8

32

9

9

9

10

36

Control investments Asset management and other fee income

101

16

13

17

13

  • 59 13

14

12

12

51

12

12

12

12

48

13

14

14

15

56

Total investment income

NOTE: Total investment income

1,051

195

140

193

169

  • 697 145

164

151

148

608

140

139

139

139

558

143

151

158

165

617

Non-controlled/non-affiliate investments

632

128

75

119

87

  • 409 78

97

75

73

323

73

73

73

73

292

76

80

84

88

328

40

9

13

14

12

48

8

7

7

7

29

6

6

6

6

26

7

7

7

8

28

Affiliate investments

379

58

52

60

70

  • 240 66

59

66

64

255

61

58

58

58

234

59

62

64

67

252

Control investments Total investment income

1,051

195

140

193

169

  • 697 144

164

151

148

607

140

138

137

137

553

142

149

155

162

608

NOTE: PIK dividend & interest

177

26

(12)

8

53

75

46

36

35

33

151

33

31

31

31

126

31

32

34

36

133

PIK div & int as % total investment income

16.8%

13.3%

-8.6%

4.1%

31.4%

10.8%

28.0%

23.8%

23.9%

23.0%

24.8%

23.4%

22.2%

22.5%

22.2%

22.6%

21.9%

21.5%

21.7%

21.5%

21.6%

OPERATING EXPENSES

 

105

   

Interest

220

52

60

85

59

256

57

56

42

36

191

32

29

26

24

110

24

26

29

31

110

206

53

47

47

68

215

34

34

34

34

136

34

34

35

35

138

35

35

36

36

142

Salaries, benefits and stock-based compensation Debt refinancing costs

0

17

0

   

General and administrative

95

26

24

28

33

111

24

15

17

17

74

16

16

16

16

62

16

16

16

16

62

Total expenses

521

131

131

160

160

582

115

122

93

87

400

82

78

76

75

311

75

77

80

82

314

530

64

9

33

9

115

49

46

55

58

208

59

61

63

65

247

69

73

77

83

303

Net operating income (before taxes) Total tax (benefit) expense

37

0

(11)

1

(10)

(20)

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

Net investment income

493

64

20

32

19

135

49

46

55

58

208

59

61

63

65

247

69

73

77

83

303

Realized/unrealized gain (loss) on investments & FX:

     

Net realized gains (losses):

Non-controlled/non-affiliate investments

37

(50)

(219)

(27)

43

(253)

(40)

(230)

(270)

Affiliate investments

(22)

(5)

0

0

2

(3)

0

7

7

117

(24)

(89)

(20)

(327)

(460)

(67)

(68)

(135)

Control investments Taxes on net realized gain

(54)

0