American Capital Strategies - Risks
- American Capital Strategies (part 1) report written 09/20/2007
- Part 2 - Risk Detail
- Part 3 - Possible Upside
- Part 4 - Competitor Review
- Part 5 - Valuation and Assessment
- Part 6 - Management & Performance Targets
- Standard industry risks:
- Credit default risk - if the economy slows down, the rate of corporate defaults would be expected to increase, thus affecting American Capital's ability to regain their investment.
- Interest rate risk - rising interest rates would increase costs and make debt more expensive. The company has $1.8B (out of ~$4B total) in revolving credit facilities.
- The asset management and private equity business generally requires highly skilled, experienced personnel who demand high compensation. This makes operating leverage very difficult, if not impossible, so expect operating expenses to rise with revenues and earnings. ACAS' stringent vetting process only exacerbates this issue.
- Market risk - American Capital depends on both capital and credit markets to finance activities. Due to strict 1:1 debt-to-equity legal requirements, ACAS depends on raising equity in the public markets as well as leveraging that equity in the debt markets for use in future investments. A freeze-up in either/both markets could prove detrimental to operations.
- Company-specific risks:
- American Capital is heavily exposed to the general US economy due to their focus on middle-market companies. While the latest reports show a heavy concentration toward financial services and away from the "old-economy" sectors, this reflects shifting many of their portfolio investments into off-balance sheet funds managed by their affiliate companies. European exposure (via ECAS) is estimated around 17% of operations.
- Some concern that they cannibalize their customers' business. Since AmCap provides debt financing for other private equity buyouts as well as executing in-house buyouts, some competitors market ACAS' possible conflicts of interest against them.
- There is some ambiguity regarding the strength of AmCap earnings. Total earnings (& EPS) is derived from net operating income (NOI) combined with realized and unrealized capital gains/losses. The realized earnings component is very lumpy as these come from exiting portfolio investments or companies. Additionally, as the company continues moving portfolio assets off balance-sheet into funds managed by ACAS affiliates, they record those transactions as earnings. The unrealized earnings are based on subjective management valuations which has been shown to be problematic in the past (i.e. capital.com was valued at $71M one year only to be revalued at $1.6M the very next year).
- The company admittedly is a trend-follower which may work against it. There have been examples of AmCap being late to the party (see above capital.com example). Possible upcoming problems may come in the form of their late entry into the asset securitization market as well as their ramp-up of their asset management segment right as questions arise about private equity and hedge funds being robust investment vehicles.
- The company has sizable (costly) personnel infrastructure, in many cases, much larger than better-known buyout firms like KKR or Blackstone.
- By definition of their business model and excluding capital gains, the company must issue equity if it wishes to grow assets under management. Traditionally, this is viewed negatively in light of shareholder interests but this standard may not apply in the case of BDCs. It depends on whether the company can increase net asset value at a better pace than diluting shareholder equity, which can be measured by NAV/share.
- The company's rapid growth in recent years fosters concerns of possible lax discipline and mal-investment.
DISCLOSURE: Please see our portfolio page for all disclosures.
This report reflects the research and analysis I've performed on this company. It is provided for informational purposes only and does not constitute personalized financial advice nor an endorsement or solicitation to purchase stock in this or any other company. Please do your own due diligence or hire a financial advisor before making any investment decisions.
The author received no compensation and is not affiliated with the company reviewed in this report with the possible exception of being a shareholder. The author reserves the right to buy or sell the stock as deemed personally prudent without further notification
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