Below are reports published concerning American Capital, they are highlighted in italics. American Capital’s discussion, comments and responses are below the relevant text and are indented relative to the articles.
Fortune: You'd think everybody would have learned by now that with high reward comes high risk. Investors might want to keep that in mind if they're lured by dividends pushing 10% at Allied Capital or 13% at American Capital Strategies, the largest of the two dozen or so public "business-development companies."
Like closed-end mutual funds, BDCs buy stakes in other companies and trade on the stock exchange. But unlike closed-end funds...,
ACAS: Mr. Greenberg is factually incorrect. Business development companies (“BDCs”) are closed-end funds under the definition set forth in the Investment Company Act of 1940, as amended (the “1940 Act”).
Fortune: ...which invest in public companies, BDCs tend to stick with small to mid-sized private companies...
ACAS: Mr. Greenberg fails to report that the 1940 Act requires that generally 70% of a BDC’s assets must be invested in private, domestic companies.
Fortune: ...that can't find funding elsewhere.
ACAS: Mr. Greenberg’s statement that BDCs “tend” to invest in companies that “can’t find funding elsewhere . . .” is absolutely false. In fact, in the vast majority of investments that American Capital makes, American Capital has competed with multiple other providers of capital interested in making an investment.
Fortune: They were created, under the same rules that govern mutual funds, to promote the flow of capital to American enterprise. By law they must pay out 90% of their taxable income...
ACAS: Mr. Greenberg’s statement that BDCs must pay out “90% of their taxable income” to shareholders is inaccurate. Actually, they are allowed to retain long-term capital gains and treat them as “deemed distributions” rather than pay them out as dividends.
Fortune: ...to avoid taxation. (See What Are Insiders Buying Now? for another investment vehicle with a similar structure but less risk.)
Most, like Capital Southwest and Equus II, take equity stakes in target companies, aiming for capital appreciation. They pay a negligible dividend but, the thinking goes, if the investments work, their stocks will rise.
However, the two giants of the industry--Allied and American Capital--with market capitalizations of $2.2 billion and $812 million, respectively, have a different modus operandi. They act more like subprime lenders, specializing in "mezzanine" loans to financially strapped companies.
ACAS: Mr. Greenberg’s statement that American Capital specializes in “loans to financially strapped companies” is false. In fact, the vast majority of American Capital’s investments are in companies with strong cash flows. For instance, in the second quarter of 2002, the weighted average interest coverage ratio for American Capital’s portfolio companies was 2.3 to 1.0 and the weighted average debt service coverage ratio for American Capital’s portfolio companies was 1.5 to 1.0.
Fortune: In return they often get both the interest payments on those loans and an equity stake in the companies. They pass on the profits from these investments to their shareholders in the form of the dividend. But beware: As both companies warn in their SEC filings, if everything doesn't go just right,...
ACAS: Mr. Greenberg’s statement about certain “warn[ings]” in the SEC filings of Allied Capital and American Capital seriously misstates the actual nature of the disclosures. The disclosures are not warnings but rather included in the risk factors section of each company’s prospectus. The American Capital disclosure on dividends states, “There is a risk that you may not receive dividends,” and continues “We cannot assure you that we will achieve investment results . . . that will allow any specified level of cash distributions or year-to-year increases in cash distributions.” This is hardly a warning that things must “go just right” in order for American Capital’s dividends to continue.
Fortune: ...these plump dividends aren't necessarily safe. And that has made Allied and American Capital magnets for short-sellers.
One of the biggest gripes: portfolio valuation. American Capital owns portions of 66 companies. Allied has stakes in some 130--from a fastener maker to a company that fills gas cylinders on barbecues. It's up to the BDCs to determine what those companies and loans are worth. Sometimes, the short-sellers contend, their estimates can be a bit generous.
American Capital, for example, had a stake in design outfit Decorative Surfaces.
ACAS: Mr. Greenberg’s statement misidentifies American Capital’s former portfolio company Decorative Surfaces International, Inc. as a “design outfit.” Actually, this company was a manufacturer of wall coverings, decorative paper and vinyl surfacing material.
Fortune: The company's finances soured, and it headed for bankruptcy. But American Capital, while writing off the equity portion of its investment, kept the full value of the debt on its books--even though the company was no longer keeping up with its payments.
ACAS: While Mr. Greenberg is correct that American Capital did not write down its debt investment in Decorative Surfaces International, he does not disclose that American Capital placed a portion of this investment on non-accrual status meaning that it was not recognizing any income from this portion of the investment.
Fortune: It then bought the whole company,...
ACAS: Mr. Greenberg’s statement that American Capital “bought the whole company,” is factually inaccurate. Actually, a new American Capital portfolio company, American Decorative Surfaces International, Inc. (“ADSI”), bought only one of Decorative Surfaces’ two manufacturing facilities. This business represented only about one-half of Decorative Surfaces’ pre-bankruptcy assets. Mr. Greenberg fails to note this transaction was approved by the Decorative Surfaces bankruptcy court.
Fortune: ...wiping out the debt entirely...
ACAS: Mr. Greenberg’s statement that the ADSI transaction “wip[ed] out the debt entirely” is inaccurate. Actually, ADSI assumed responsibility for the debt obligations owed by Decorative Surfaces to American Capital.
Fortune: and preventing the loan from becoming a loss. Had it counted as a loss, that could well have hurt the dividend.
ACAS: Mr. Greenberg’s statement that a loss on the Decorative Surfaces loan could have hurt the American Capital dividend is factually inaccurate. If American Capital had written down some or all of its loan to Decorative Surfaces, any loss American Capital would have recognized would have been a long-term capital loss. In its five years as a BDC, American Capital has never made distributions of long-term capital gains to its stockholders. Therefore, it is unlikely that a long-term capital loss would have led to any reduction in the company’s dividend.
Fortune: BDCs also count on capital gains to help make up their dividend payout.
ACAS: Mr. Greenberg’s statement that BDCs “count on capital gains” for dividend payments is not necessarily accurate. Actually, BDCs need not make distributions of long-term capital gains and, in fact, American Capital has made no distributions of its long-term capital gains in its five years as a BDC.
Fortune: This year, Allied says, gains on its investments will cover 12% of its dividend, up from just 1% last year. The trouble with relying on capital gains, says hedge fund manager David Einhorn of Greenlight Capital, is that they're discretionary and unpredictable. Last year, for example, Allied booked a record $60 million capital gain from selling training company Wyotech. This year it'll need at least that much, but Einhorn says Allied would have to sell off a massive portion of its portfolio to come up with that kind of cash again. Allied says it needs to sell only one or two of its companies to meet its needs.
Finally, critics of American Capital say the company simply pays out more in dividends than its operations bring in. For the first six months of this year, operating cash flow was $22.6 million, while dividends totaled around $50 million.
ACAS: Mr. Greenberg’s discussion of American Capital’s dividend and the sources for its payment fails to disclose that American Capital, as part of its normal operations, pays a portion of its dividend from the repayment of principal on its loans. An extensive discussion of this appears on American Capital’s website at www.ACAS.com/Response.html. (The portion paid does not reduce American Capital’s income producing capital.) Additionally, Mr. Greenberg has discussed this matter on several occasions with American Capital’s senior officers. This is a material omission from this discussion.
Fortune: "That's simply not true," says CEO Malon Wilkus, who contends that investors have to look at items other than operating cash flow, such as interest that is deferred until the loan is repaid, which eventually will be collected as income (assuming it is collected).
ACAS: Mr. Greenberg’s use of this quote from Mr. Wilkus is absolutely out of context. As it appears in this article, Mr. Wilkus appears to be quoted that the information on operating cash flow and dividends cited by Mr. Greenberg was inaccurate. What Mr. Wilkus’ quote concerned was Mr. Greenberg’s repeated assertion on the RealMoney.com website (which is operated by TheStreet.com) that American Capital pays out dividends from its sales of American Capital stock. Mr. Greenberg curiously omits this assertion from his Fortune article, apparently because he now realizes its inaccuracy. Mr. Greenberg’s quote of Mr. Wilkus is also inaccurate in that Mr. Greenberg fails to report how Mr. Wilkus has explained to him on several occasions how American Capital’s cash flows support the company’s dividends.
Fortune: All of this, the short-sellers say, puts the consistency of the dividend in jeopardy. Allied insists it values its investments properly, and points out that it has paid, and grown, its dividend for 40 years--an impressive feat. But the company is a very different beast than it was even five years ago. It's much bigger and more exposed to the dicey economy. American Capital CEO Wilkus also says the company values its investments fairly. The biggest risk to its dividend, Wilkus says, is a recession deeper than the last one.
ACAS: Mr. Greenberg’s paraphrase of his discussion with Mr. Wilkus is inaccurate and incomplete. Mr. Wilkus actually stated that even if investments on non-accrual status doubled from current levels, American Capital would expect to be able to continue its current dividend because of variable costs and other factors.
Fortune: Perhaps, but bear this in mind: Whenever "business takes a sharp downturn ... to keep the dividend steady, they have had to do some heroics in the portfolio," says hedge fund manager Mark Haefele of Sonic Capital.
ACAS: Mr. Greenberg’s identification of Mark Haefele as a “hedge fund manager” is at best incomplete. He fails to disclose that Mr. Haefele is also a columnist for RealMoney.com and TheStreet.com, Mr. Greenberg’s principal employer, and that Mr. Haefele has publicly stated that he is short in American Capital stock.
Fortune: That could become tougher and tougher if the economy sputters. And if the dividend suffers, what's the point of owning these stocks?
Fortune: Herb Greenberg is a senior columnist for TheStreet.com.
ACAS: Nowhere in Mr. Greenberg’s discussion is there disclosure that David A. Rocker, the third largest stockholder in TheStreet.com, is short in American Capital and as of June 30, 2002, managed naked puts in Allied Capital.
September 18, 2002
Time & Life Building
New York, New York 10020
Re: September 30, 2002 Column by Herb Greenberg
We at American Capital Strategies, Ltd. (Nasdaq: ACAS), were surprised and disappointed to see posted on your website this week a copy of a column by Herb Greenberg of TheStreet.com, which will apparently appear in the September 30, 2002 issue of Fortune. In publishing the column, the well-earned reputation of Fortune for scrupulous fact checking has been seriously tarnished. We have enclosed an annotated copy of the article showing more than a dozen errors, factual misstatements and material omissions. Many of these items had actually been explained to Mr. Greenberg in a series of communications we had over the last several days.
Perhaps the most curious omission is that the article fails to disclose Mr. Greenberg’s connections to the shorts who have been practicing a “short and distort” strategy with regard to the stock of American Capital and its fellow business development company, Allied Capital Corporation (NYSE: ALD). According to TheStreet.com’s 2002 annual meeting proxy statement, the third largest stockholder of TheStreet.com is David A. Rocker. Mr. Rocker controls more than 12% of TheStreet.com’s outstanding securities. Mr. Rocker is a well known short. Mr. Rocker's fund, Rocker Partners, has acknowledged to American Capital that it is short American Capital’s stock. Additionally, Mr. Rocker’s own filings with the Securities and Exchange Commission disclose that as of June 30, 2002, he managed naked puts for over 230,000 shares of Allied Capital stock. Naked puts, of course, are a well known strategy of short sellers. Additionally, Mr. Greenberg quotes approvingly in the article an individual without identifying him as a colleague of his at TheStreet.com who has publicly stated that he holds a short position in American Capital stock. Yet, nowhere in the Fortune article are these interests disclosed.
These omissions, together with the other factual inaccuracies and omissions noted in our annotated version of the article, lead us to conclude that Fortune has been used as a vehicle by short sellers to manipulate the market in American Capital stock.
We sincerely hope you will give us an opportunity to correct Mr. Greenberg’s numerous false and misleading statements.
Chairman, President and CEO
TheStreet.com (TSC): A sharp reader wrote to ask if, given all that this web site has said about ACAS, is the ACAS Chairman crazy for recently adding to his ACAS holdings?
First, his recent purchase is very small. Second, the company loaned him the money that built most of his stake.
ACAS: The facts are that Mr. Wilkus purchased 68% of the stock he owns with no assistance from the company and has never sold a share.
The stock option loans that Mr. Wilkus has outstanding are part of a company-wide stock option loan program. The loans must be fully secured at all times, and the Company has full recourse to Mr. Wilkus. These are the only loans that Mr. Wilkus has from American Capital. Based on recent legislation for all public companies, senior management will no longer be able to participate in the stock option loan program. Virtually all of Mr. Wilkus’ net worth is invested in American Capital. (See Section IV, D4.)
TSC: This is from the latest ACAS proxy:
The Company has entered into a series of loan transactions with most of the Executive Officers pertaining to the exercise of options under the Employee Option Plan. In each case, the Company lent to the Executive Officer the full option exercise price, which ranged from $15.00 to $22.875 per share of Common Stock, plus additional sums for the payment of taxes associated with the exercise of the options. The total amounts lent were $4,230,949.29 to Mr. Wilkus. Mr. Wilkus' loans remain outstanding.
So the real question is whether or not the Chairman is crazy to take a large stake in ACAS stock with money he borrowed from the shareholders? As of 6/30, ACAS had about $33M in loans outstanding to their employees.
TSC: Fantastic article on American Capital Strategies (ACAS:Nasdaq) today by Herb Greenberg. Herb points out that the company finally responded to its critics, but with the same defenses they and their analysts had previously mounted. As I noted in this space on Wed., they argue that they have money to pay a cash dividend today, because they are accruing non-cash interest that will be realized at some time in the future. At that point, it will all balance out. In the meantime, the cash to fund the dividend comes from the repayment of principal on existing loans.
ACAS: The facts are, the only way to collect in cash the PIK Interest accrual and OID accretion is through principal repayments. (See Section IV, B10.)
TSC: As Herb notes, OID and PIK are now 36% of the dividend.
ACAS: The number above fails to include several key line items of cash collections in the Statement of Cash Flows. When included, the amount of non–cash revenue booked in prior periods and not subsequently collected in cash or offset by capital gains totals 11% in the aggregate and 7% in the Pre-1999 Static Pool. (See Section IV, C2.)
TSC: The observation of myself and many other people who have looked over ACAS's financials is that the cash flow from operations does not come close to meeting the dividend payouts, which are based off taxable earnings. So what does the company do to "prove" the critics wrong? In their spreadsheet, they start with the Operating Cash Flow, add back the working capital changes and the non-cash components of earnings, to get to the taxable earnings. This is novel logic, indeed. They are basically running their statement of cash flows in reverse. If you add back in all the adjustments to taxable earnings that reconciles it to Operating Cash Flow, you end up with... taxable earnings. So the company has essentially proved the tautology that taxable earnings is equal to taxable earnings.
ACAS: Under GAAP, when a finance company charges PIK Interest and or warrants, Cash collection of PIK Interest accrual and OID accretion is treated as a principal repayment and reflected in the Statement of Cash Flows below the Operating Cash Flow line. These amounts must be added back to Operating Cash Flow to determine cash flow available to pay dividends without reducing total investment levels. (See Section IV, B7 and B10.)
Note, as long as the amount of principal repayment used to pay the dividends does not exceed the accrual of PIK Interest into principal and the accretion of OID into discounted notes, there is no decrease in portfolio investments. (See Section IV, B5 and B9.)
TSC: There are so many intersting things about this company that keep popping up, I hope to write more soon.
TSC: A Fried Day:
TSC: Dividend dollop: Among the controversies surrounding American Capital perhaps none is more compelling than whether the business development company can keep paying its hefty dividend without continually selling stock to the public.
ACAS: American Capital has raised debt and equity capital to fund our growth. In fact, in the five years since our IPO, we have invested $1.258 billion in working capital and new investments, but have raised only $1.139 billion of debt and equity. The balance, $119 million, was funded with net capital gains and principal repayments. (See Section IV, B11.)
TSC: Reason for the concern (in its simplest form) is that American Capital, which lends money to companies that can't get cash elsewhere, ….
ACAS: In fact, there typically is considerable competition to finance the middle market companies in which we make investments.
TSC: ….is doling cash ….
ACAS: American Capital does not dole out cash; rather we invest at competitive market terms, after performing extensive due diligence and completing a rigorous investment decision process.
TSC: ….out at a far greater rate than its operations are bringing it in. For the first six months of 2002, for example, the company earned just $15.8 million while paying out more than $50.6 million in distributions.
ACAS: It is not informative to compare Net Income to dividend distributions because of broad swings in unrealized appreciation and depreciation. You can see the broad swings by reviewing past financials, for instance in the first six months of 2002, we recorded $32 million of unrealized depreciation, and in 1999 we recorded $70 million of unrealized appreciation. Net Income contains unrealized appreciation and depreciation whereas Taxable Income does not. We are required to base our dividend on Taxable Income.
TSC: So where does it get the money to pay its dividends?
ACAS: From cash flows from our portfolio companies. In the five years, since our IPO, we have collected $119 million more in cash flow from our portfolio companies than we have needed to pay our dividends. (See Chart in Section IV, B8a.)
TSC: Critics insist a great deal of the cash comes from stock offerings, and that in effect, money is going from one class of investors to another.
ACAS: If this were true, American Capital would have to report to its stockholders that a portion of its dividends were a return of capital. That has never been the case. (See Section IV, B3.)
TSC: In the past year alone, they note, American Capital raised $175 million via three offerings.
ACAS: True, but American Capital has also made over $480 million in new investments over the past year. Though we have been able to use $119 million of capital gains and principal repayments to fund investments over the five years since our IPO, we still must raise debt and equity capital to fund our high level of investment growth. (See Section IV, B11.)
TSC: American Capital, using fancy slides and explanations on its Web site, maintains that the dividend money comes from a variety of sources -- all internal. I should point out, however, that in an interview several weeks ago, CFO John Erickson told me that "the cash is fungible once it comes in the door. ... You don't say this is interest income cash and this cash is equity cash. He then went on to insist that "cash from equity is not used to pay the dividend."
ACAS: It is true that cash is fungible, but we can identify the sources of cash flows from our portfolio companies and easily determine that we have received $120 million more in cash from our portfolio companies than has been needed to fund dividends in the five years since our IPO. (See Section IV, B7.)
TSC: On Wednesday American Capital even snuck in an updated defense of itself, with more charts and graphs and a long-winded explanation about why its critics are wrong.
ACAS: In our press release dated
It’s true that our answers are detailed, because the operations of a publicly traded buyout and mezzanine fund requires considerable explanation, particularly since we have few public peers. In the five years since our IPO, we have made extensive disclosures including lengthy slide presentations. Most of the slides used in the discussion above have been used previously to explain our business.
TSC: The company's defense (coincidence of coincidences) appeared on its Web site a day after a similar explanation was published by big bull Joel Houck of Wachovia Securities. The bottom line of the company's argument is that while the cash-flow statement might show a deficit, the company operates as if the cash, so to speak, were in the bank.
ACAS: There is no “deficit” in our Statement of Cash Flows. It shows that we have received $120 million more in cash flow from our portfolio companies than has been needed to fund dividends, in the five years since our IPO. (See Section IV, B7.)
TSC: A big part of the calculation of cash available for the dividend (for tax reasons the company must pay out 90% of taxable income as distributions) includes interest that is owed but not currently being collected. As part of its loans, American Capital often gets warrants or stock in the portfolio companies. If American Capital has doubts about whether the value of the warrants or stock will rise over the term of the loan, it will let the portfolio company defer paying part of the interest when the interest is due, and instead make a "payment-in-kind." This payment-in-kind accrues and is due when the loan matures. Many of these loans are also like zero-coupon loans, which means the discount is also due at maturity.
ACAS: Our loans are not structured as zero-coupon bonds. Zero-coupon bonds are purchased at a discount to their maturity value. No payments are received from the purchase date until the maturity date. Our loans typically require interest and in (many cases) principal payments prior to the maturity date.
TSC: It is those eventual payments, the number of which changes routinely as new loans are made and others are paid off, that American Capital is counting on to help pay the dividend.
ACAS: We have not counted on “eventual payments” to fund our dividends; we have had more than enough cash flows from existing investments to pay dividends, in the five years since our IPO. During that time, we have received cash payments of $334 million from our portfolio companies and have paid $214 million of dividends. (See Section IV, B2.)
TSC: Here's the rub: According to figures provided by American Capital, noncash payment-in-kind interest and the accretion of loan discounts -- which is really nothing more than another form of noncash interest -- catapulted to 35.7% of dividends paid in the first half of this year, from 7.4% in 1998. At the same time, the amount being paid out in dividends is ballooning, as the company boosts its payout on an expanding share base.
ACAS: The complete set of numbers referred to in the paragraph above for 1997 through the first six months of 2002 are 67.7%, 7.4%, 23.7%, 7.1%, 28.8%, 35.7% respectively. The timing and amounts of investment exits, changes in working capital and other factors cause these numbers to vary considerably from period to period.
In addition, the 35.7% number above fails to include several key line items of cash collections. When included, the amount of non–cash revenue booked in prior periods and not subsequently collected in cash or offset by capital gains totals 11% in the aggregate and 7% in the Pre-1999 Static Pool. (See Section IV, C2a.)
TSC: In an effort to assuage concerns of investors, Houck, the Wachovia analyst, points out that over the past four years American Capital has brought in $3.4 million over the amount of dividends paid out. Sounds impressive until you realize that he's using all these funny-money IOUs to get a big part of the surplus.
ACAS: The analysis described above, only took into account cash received from portfolio companies. And, in addition to this $3.4 million amount, we also received in cash $120 million of additional principal repayments. (See Section IV, B8a.)
TSC: Put another way, the quality of American Capital's portfolio is deteriorating along with the economy and the stock market -- both of which are critical to American Capital's ability to pay its dividend and keep its loan portfolio growing. "We've told people that if we have a double-dip recession it could be trouble for our portfolio," Erickson said.
ACAS: The full contextual comment by John Erickson, was that we've told people that if we have a double-dip recession it could be trouble for our portfolio. We could see non-accruals rise and more depreciation in the portfolio, much like we saw in 2001. But, we estimate our non-accruals could double and we could still meet our NOI forecasts. (See Section IV, D2.)
Considering the recession and the impact of the terrorist attacks in September of 2001, we believe the performance of our portfolio has been good. In the five years since our IPO, we have exited $149 million of portfolio assets, with a 25% IRR and total net realized capital gains totaling $13 million. Our net unrealized appreciation and depreciation plus our net realized gains and losses on our portfolio investments have totaled $34 million of net depreciation on our $1.1 billion portfolio. We have $236 million of equity interests in our portfolio companies. (See Section IV, C1.)
TSC: (That's so because if the company can't raise more cash, its loan portfolio won't grow, and if its loan portfolio doesn't grow, noncash PIKs become a higher percentage of interest income, making the cash needed for dividend payments harder and harder to come by.
ACAS: We expect the opposite to occur. As the loan portfolio matures, the percentage of cash collection of accrued PIK Interest and accreted OID from prior periods become a higher percentage of cash flow. (See Section IV, C2.)
It’s easier to understand by reviewing a steady state analysis of a Business Development Company having a portion of its revenues in the form of accrual of PIK Interest and accretion of OID. It shows that a BDC can maintain dividends indefinitely as long as gains cover losses. And, dividends can grow if gains exceed losses. (See Section IV, B5.)
TSC: The wild card, as it applies to dividends, is the valuation of the company's investment portfolio. Dividends are calculated off taxable income, which includes net operating income and realized gains and losses from investments -- not net income, which includes unrealized gains and losses as well. The weaker the portfolio, the greater the possibility that some of those unrealized losses become realized losses, which could hurt the dividend. And without a hefty cash payout this stock will really lose its luster.)
Let's just say if there's any glitch in American Capital's assumptions, investors may wish they had paid closer attention to the risk that goes along with the reward.
ACAS: Our Net Operating Income (NOI) guidance for 2002 is $2.54 to $2.63. If any of our depreciated investments were to become realized losses, it would not impact our ability to pay our dividends. (See Section IV, D1.)