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Ares Capital’s proposed acquisition of American Capital: Good Enough ?

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Finally ! The long and winding road for American Capital (ACAS), which has been in transition since the Great Recession and undertaking a “strategic review” for many months after a long winded and failed attempt to spin off its loan assets into two (!) BDCs and convert itself into an asset management company failed, has come to an end. The mortgage business management of American Capital is being acquired by American Capital Agency (AGNC),  its publicly traded mortgage REIT. That’s a whole story unto itself but the BDC Reporter is mostly concerned with the leveraged finance business. That is being sold-lock, stock and barrel to industry stalwart  Ares Capital (ARCC).

WHAT’S IN IT FOR SHAREHOLDERS ?

What will American Capital shareholders-who’ve been kept in the dark for months about what’s been happening in the  conference rooms of Wall Street-get after holding their breath these many months ? In a nutshell: a mixture of cash and stock. We quote from the press release:

American Capital shareholders will receive $1.470 billion in cash from Ares Capital, or $6.41 per share, plus 0.483 Ares Capital shares for each American Capital share, resulting in approximately 110.8 million Ares Capital shares, or $1.682 billion in value or $7.34 per share based on Ares Capital’s closing stock price of $15.19 as of Friday, May 20, 2016, issued in exchange for approximately 229.3 million American Capital shares. Following the transaction, Ares Capital shareholders are expected to own approximately 73.9% and American Capital shareholders are expected to own approximately 26.1% of the combined company.

GOOD OR GOOD ENOUGH ?

It’s a patchwork of a deal, and like everything associated with American Capital in recent years leaves one wondering if one’s pocket is being picked or is that as good as it gets, given the potpourri of investment assets American Capital had acquired (not one but two mortgage REITs, European loans and investments, venture capital deals, huge sponsor-financing loans and control positions in middle market companies, real estate holdings and Uncle Tom Cobley and all). We hear from Ares Capital that the portfolio will be “re-positioned” in the months ahead. That’s lender speak for selling a bunch of investments at the best price available, and should result in a portfolio that will look more like the buyer’s than the seller’s.  That’s probably a Good Thing as the very diversity of the American Capital portfolio resulted in the need for multiple-and very expensive specialized management teams-and made the company a “black box” from an investor’s standpoint. First out of the door will be the mortgage REIT managers as we’ve discussed at the top. We expect Ares might sell off the large CLO exposure ACAS has acquired, as well as the European loan and equity business, but we’re just guessing.

SELL, SELL, SELL

There have been a flurry of ACAS realizations in recent weeks of control investments-never of great interest at Ares Capital, which sees itself as a partner to the large Private Equity groups out there rather than a competitor. We expect there might be more sales on the docket if the opportunity arises and no new additions to that type of business-where ACAS provided both debt and equity to acquire U.S. companies. In fact, the press release directly addresses the subject:

Prior to closing, American Capital may continue its plans to monetize certain investments (in collaboration with Ares Capital) and the proceeds of any such sales would be used to retire indebtedness or to remain in cash balances as the company has ceased its stock repurchase. Since March 31, 2016, American Capital has announced sales of over $550 million in balance sheet investments.

  The low yield, lower risk highly liquid loan book has already been sold off, only a year or two after ACAS bulked up on those kind of assets.

Sign roads going two ways

BUY, BUY, BUY

Instead, Ares Capital intends to re-direct all that freed up capital into “directly-originated investments”. We have not had time to run the numbers but expect that once all the dust settles and American Capital’s assets are “re-positioned” a year or more from now most of the investments that currently appear on the ACAS books will be gone. If ACAS shareholders want to know what their investment will look like from a risk and return standpoint, we suggest they look over at the current balance sheet of Ares Capital because that’s what you’re going to own, but in greater bulk.

Obviously, this is probably a very good deal in the long term for Ares Capital.  Based on the very competent purchase by Ares of Allied Capital several years ago when that other former behemoth of the BDC-world was up for grabs we imagine the would-be buyers have been through the portfolio with a fine tooth comb and already have a game plan for every loan, investment and knick-knack that the ACAS managers have assembled.  ARCC’s parent Ares Management have been roped in to put up some of the cash for the acquisition (as well they should as this will make them a huge amount of money in years to come).

GOOD DEAL FOR ACAS SHAREHOLDERS ?

Already law firms are circling, and arguing that the proposed deal is not favorable to ACAS shareholders. Presumably, there’s still a chance someone will step up and make a better offer. (Will Prospect Capital-PSEC-make a last minute charge like they didApples and Oranges On Scale during the Allied transaction ? We don’t think so, but the ensuing drama would make for great copy). Without the benefit of all the access Ares and other potential buyers (and this has been hawked all over the financial world we presume) it’s very hard to say, but seems unlikely. Unlike some other “sweetheart” deals in the BDC space where busted BDCs have been sold off without the benefit of an auction, there appears to have been a true auction conducted here. We doubt there are too many groups out there, given the hundreds of investments at ACAS involved, as well as all the complexities of an internally managed BDC where the managers have negotiated very favorable compensation and termination terms over the years that have to be contended with, who might want to go through the headache of a last minute challenge.

BRASS TACKS

The BDC Reporter is going to be practical. This has gone on long enough, and is not to the benefit of ACAS shareholders to continue in the limbo that has existed for many quarters as ACAS lost any strategic direction (one day we were going to have multiple BDC spin-offs, then we were back to one BDC, etc.). Many key assets have already been sold and many managers are already out the door or actively on LinkedIn looking for work.

THE ELEPHANT IN THE ROOM AND WITH THE VOTES

Most importantly “BDC activist” and king-maker Elliott Management has agreed to support the deal when shareholders get to vote. Here is their just amended Support Agreement. In the press release announcing the transaction Elliott Management’s support was highlighted, both to underscore to shareholders that a sophisticated investor has blessed this Chinese puzzle of a transaction and to remind anybody would might be contemplating a No vote that Ares has the votes-or at least 14.4% of them. Here is the language:

Elliott Management, holder of a 14.4% interest in American Capital, strongly supports the transactions and will vote its shares in favor at the upcoming Special Meeting. Portfolio Managers Jesse Cohn and Pat Frayne said in a statement, “We are pleased with the result of the Strategic Review and thank the Independent Board Committee of ACAS for its hard work and success in delivering an excellent outcome for shareholders. We believe this transaction represents the best path forward for ACAS shareholders and creates a tremendous opportunity for value creation as shareholders of Ares Capital after the deal is completed. ACAS’s streamlined portfolio will benefit from management by an Ares team that has a stellar track record of delivering shareholder value.”

THE NEVER ENDING STORY

Given that ACAS shareholders are being offered both cash and shares in Ares Capital the key question is less about what American Capital is worth, but whether Ares Capital is a good place to be invested. Obviously Ares has proven itself over the years a far better steward of shareholders capital than American Capital. Of all the bigger BDCs, they have been one of the more generous (less rapacious ?) on management and incentive fees, and have been careful not to abuse shareholder trust by raising capital below NAV. Credit quality and Net Asset Value have been very stable in a way that competitors like Fifth Street Finance, Medley Capital and-most recently-BlackRock Investment can only dream of. Of all the potential buyers that could have acquired ACAS, Ares Capital has to be towards the top of most shareholders wish list, barring just getting full value in cash and being able to decide to re-invest in whatever one chooses.

A YEAR IS A LONG TIME IN LEVERAGED FINANCE

Nonetheless, our job is to worry about risk (in this case-if things work out return will look after itself with Ares already claiming the deal will be “immediately accretive to core earnings per share”). In this case, ACAS and ARCC shareholders will have to worry about what happens to market conditions in the many months ahead, if conditions remain as they are, many more assets will be sold off at par or above. If conditions deteriorate, we may have one of those Warren Buffet situations where we find out who was swimming naked when the tide goes out. There are going to be many moving parts-most of which will be shifted around quietly and intra-quarter behind the scenes-which will make evaluating what the pro-forma picture for Ares Capital will look like. Faith and fingers crossed will be necessary, and the sense that the buyer has not hobbled itself by over-paying, but there’s no guarantee that the ACAS assets might not yet drag down Ares.

AMBITION

Then there’s the risk inherent in the ambition of Ares Capital, and its publicly traded parent Ares Management. In recent years we’ve noted the ever increasing risk profile of the BDC’s portfolio, both on balance sheet and off balance sheet. We’ve written before that we’re concerned-as were some of the rating agencies at times-at the use of its joint venture with GE Capital (and now with Varagon) to take on much higher effective leverage than the BDC rules allow on balance sheet. Moreover, to boost earnings and protect the dividend, Ares Capital has continued to invest heavily in second lien and riskier investments in recent quarters even as many signs of the possible Credit Apocalypse have been gathering. To date, all those concerns have not translated into any great deficit in credit losses (although IVQ 2015 results were not stellar) or any material drop-off in profitability. Management continues to argue that they are as cautious and conservative as they’ve ever been, but could they say anything else ?  With the bulking up in the total size of Ares Capital (and the ultimately huge boost in recurring management and incentive fees that will follow for the parent) we worry that high leverage (even if disguised by holding assets off in its joint ventures) and credit risk taking will continue, but on a bigger scale.

SPONSOR FINANCE

To be specific, we’re not huge fans of the staple of Ares Capital’s lending activity-financing very large sponsor financed buy-outs. Yes, the lender has a moneyed and experienced partner in the Private Equity groups involved (Ares Capital works with the Best, the Brightest and The Biggest), but this is a highly competitive business where spreads are thin. Yes, credit losses have been very low in recent years, but this has been a long expansionary period. Yes, Ares has operated successfully in this arena thanks to the firepower available from its relationship with GE Capital (and now with the extra capital from ACAS shareholders) and by taking on most of the credit risk involved in return for a mid-teens (!) all-in return. However, the time may come when the piper has to be paid and the exposure to these very large buy-outs may result in out-sized losses that will surprise current shareholders, and the newly arrived former ACAS owners who might have thought they were done with such drama.

CONCLUSION

Ares Capital is buying out American Capital at what appears to be a reasonable price point. We expect the deal will go though when voted on in July. ACAS shareholders should take comfort that their assets will no longer be managed by a self-serving and inefficient American Capital management organization and will be entrusted to one of the most successful BDCs of all time.  Yet, this story is not over because much can happen in the short term to the market and in the long term as Ares Capital presses on with its strategy of big ticket lending, and taking every advantage of the capital markets to maximize asset deployment.

DISCLOSURE

We were Long both American Capital (in our Fund and in our BDC Value portfolio) and in Ares Capital (in just our BDC Value portfolio) at the open. In our Fund, the ACAS position was a Best Idea (we only have two or three at a time, and this leaves us with only two left). We hoped to make a capital gain and get out when the acquisition came to fruition, which we did today. We bought ACAS at $14.0456, and sold at $15.73. That’s a 12% gain over about 120 days (we bought in January) or about 36% annualized (which always sounds better). We would not be surprised if the price moved up after the deal is approved and some of the uncertainties removed. However, we’re in a “take-the-money-and run” mood after a long holding period for this particular Best Idea. ACAS management have taken a very long time to accept the inevitable and sell. We typically hope our Best Ideas will prove themselves out in a matter of weeks.

By the way if anybody is interested in knowing what our other two Best Ideas are (we have not had time-with all the energy spent on the BDC Credit Reporter-to write them up here), please drop us a line at nmarshi@southlandcapitalmanagement.com, and we’ll be happy to let you know. Both are still playing out and trending in the right direction.

We are keeping our position in Ares Capital in our BDC Value portfolio, where we take a longer term view (5 years or more). The stock price drop today of ARCC (down 2.4%) does not bother us. We have enough confidence in the buying capability of Ares Capital (even if their judgement may be partly clouded by the prospect of all those extra management fees). We hope for a greater pull-back to add to our position.

  • ARCC, ACAS

 

 

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