On 12-9-2015, a newly formed, anonymous firm called FultonView Research published a report on American Capital, Ltd., that said the company’s asset values were inflated and unreliable. FultonView said that proposals from activist investors were based on the assumption that the company’s reported NAV was a true reflection of underlying assets, but it said that American Capital’s reported NAV was a product of the company’s management abusing Level 3 subjectivity. FultonView additionally said that American Capital had unloaded a number of investments into private equity funds it managed, which FultonView said then underperformed, and it said that American Capital then bought some of the assets back and wrote them down in “a shell game to justify its book value.” FultonView also said that a recently raised private equity fund was structured to enrich a “self-serving” management team by as much as $500 million at the expense of shareholders, and FultonView said that the transactions could trigger an SEC investigation. It estimated 37% downside, or a price target of $8.97 per share. Summary via Activist Shorts Research.

A famous short biased hedge fund manager told ValueWalk that the report was impressive and pointed out that the ability to grow may be gone and issues may arise as credit spread rise. Other prominent investors take the opposing side including Paul Singer. Elliott Management did not immediately respond from ValueWalk for to a request for comment. See the full report below.

Short Case For American Capital Ltd. (ACAS)  by FultonView Research

Executive Summary

  • American Capital’s asset values are, in our opinion, inflated and unreliable. The majority of ACAS’ book value is categorized as Level 3 assets, which is subject to management judgment. Upon analyzing some of ACAS’ largest investments based on ACAS’ own financial statements and other documents in the public domain, we have identified what we believe is evidence of dramatically inflated investments.
  • A review of its history suggests that American Capital has unloading a number of investments into private equity funds it manages, which have then underperformed, only to buy some of the assets back and write them down in what we believe amounts to a shell game to justify its book value.
  • A recently raised private equity fund is structured to richly reward management. A number of assets from American Capital have been sold to the fund only to be quickly flipped at substantial premiums. In the process, we believe management has enriched themselves by as much as $500mm at the expense of shareholders. Precedent suggests these transactions could trigger an SEC investigation.
  • We have no faith in ACAS book value or its management team. We believe the company’s assets are inflated and value ACAS at $8.97 per share with a view of 37% downside.

Background

American Capital is a $3.7bn BDC that operates as an alternative asset manager and private equity firm. What sets ACAS apart from other BDCs is that it has become the hot target of a laundry list of well-known activist hedge funds that have been pushing ACAS to unlock shareholder value.

While the activist funds all have their own idea of how to turn around American Capital, the consistent theme is to reduce the gap between share price and NAV. Orange Capital for example, is demanding that ACAS spin-out its asset management business from the investment portfolio, and buy back shares to reduce the NAV gap. More recently, Elliott Capital Management stepped in to urge shareholders to vote against the spin-out, and undergo a full review of the assets. Elliott believes that in the best case the shares can trade at a mere 10% discount to NAV (from the current 30% discount).

We believe that the issue here is not ACAS’ discount to NAV but rather its self-serving and entrenched management team – supported by an incapable board – who have enriched themselves at substantial cost to shareholders. Both Orange Capital and Elliott dedicate large sections of their public commentary to criticizing management for the lack of governance and accountability, yet ironically seem to take the financial statements issued by that same management team at face value. We believe these funds are basing their thesis on the assumption that the NAV reported by American Capital is a true reflection of its underlying assets.

We believe that their assumption is wrong.

This research report provides evidence that we believe shows that American Capital management has enriched themselves at considerable loss to shareholders, that ACAS’ portfolio is dramatically inflated, and that the NAV value it reports to investors is a product of management abusing Level 3 subjectivity. Although activist investors have been proposing creative ways of narrowing the gap between share price and NAV, they have seemingly given little thought to the reliability of the reported NAV figure itself. In these way, ACAS reminds us of the subprime crisis where a lot of smart people were so busy structuring and packaging financial products that they paid little attention to the underlying assets.

We believe that here, American Capital shareholders are holding shares in a company that is worth far less than its books suggest.

Level 3 Pixie Dust

The majority of American Capital’s investments are illiquid and have no active primary or secondary market. These investments are considered “Level 3” assets, which means their value cannot be observed or corroborated by market data, and are instead estimated by the ACAS Board of Directors. From page 62 of the ACAS 2014 10-K:

“Portfolio Valuation

Our investments are carried at fair value in accordance with the 1940 Act and ASC 820. Due to the uncertainty inherent in the valuation process, such estimates of fair value controls may differ significantly from the values that would have been used had a ready market for the securities existed, and the differences could be material. Additionally, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses ultimately realized on these investments to be different than the valuations currently assigned. As of December 31, 2014, the fair value of 68% our investments were estimated using Level 3 inputs determined in good faith by our Board of Directors because there was no active market for such investments.”

Ominously, at year-end 2014, 68% of American Capital’s portfolio was valued by its Board of Directors – a board, which, according to Elliott, has no discernible investment experience and lacks the relevant experience to govern the behavior of the investment team and hold management accountable:

American Capital

American Capital

See full PDF below.