Fitch Ratings has placed the 'BB-' Long-term Issuer Default Rating
(IDR), 'BB+' senior secured debt, and 'BB-' senior unsecured debt for
American Capital, Ltd. (ACAS) on Rating Watch Negative. Today's rating
actions are taken as part of Fitch's periodic review of Business
Development Companies (BDCs), which encompasses 10 publicly rated firms.
BDC INDUSTRY OUTLOOK
Fitch's outlook for the BDC sector is negative; reflecting competitive
underwriting conditions, earnings pressure, underperforming energy
investments, unsustainable asset quality metrics, increased activist
pressure, and limited access to growth capital. While some firms are
better positioned, given their more conservative financial profiles and
portfolio characteristics, others are likely to see rating pressure over
the outlook horizon.
BDCs are heavily dependent on the equity markets to fund portfolio
growth, but access to the market has been almost non-existent over the
last 18 months as share prices continue to trade at steep discounts to
net asset value (NAV). At March 7, 2016, rated BDCs were trading at a
18.3% average discount to NAV, thus preventing most from issuing stock
without significantly diluting existing shareholders. While the
reduction in portfolio growth is viewed favorably by Fitch, given tough
underwriting conditions, some firms may struggle to close the trading
gap, leaving them at a competitive disadvantage if and when investment
opportunities arise.
The decline in commodity prices has yielded the first notable crack in
asset quality performance for BDCs. More broadly, asset quality metrics
remain at unsustainably low levels, in Fitch's opinion. While strong
portfolio company performance has been supported by an improving
economic environment, low interest rates are likely masking some
potential underlying company-specific issues, as issuers have been able
to refinance themselves out of trouble rather easily in recent years.
Fitch believes asset quality metrics are likely to deteriorate over the
near term; however, the pace of deterioration will be somewhat dependent
upon the rate of change in interest rates, the backdrop of the broader
economic environment, differing sector exposures, and the integrity of
individual firms' underwriting.
Fitch has not observed a marked increase in leverage levels for the
sector, with average leverage for investment grade-rated BDCs of 0.74x
at year-end 2015 compared to 0.60x at year-end 2014. However, there is a
wide dispersion of leverage around the average, and those with the most
energy exposure often also have the highest leverage ratios. Share
repurchase activity has also increased in the sector in recent quarters,
which could inflate leverage ratios further. Fitch believes that BDCs
heavily focused on maximizing leverage run the risk of having less dry
powder to deploy when if and when underwriting conditions improve, thus
weakening earnings upside.
KEY RATING DRIVERS
IDRs AND SENIOR DEBT
The Rating Watch Negative stems from potential changes in ACAS's
strategy, organizational structure, and/or ownership over the near- to
medium-term, which are more likely to translate into negative rating
actions, in Fitch's opinion, given the complexity of the business model,
relative to other BDCs. Currently, ACAS is soliciting bids for the sale
of its business in whole, or in parts.
If ACAS should pursue a partial sale, an orderly liquidation of its
business or if the firm is unable to sell its business, that could
translate into negative rating action.
Should ACAS pursue a full sale of its business, Fitch would assess the
credit worthiness of the potential acquirer or acquirers. All things
equal, the sale to a higher-rated entity could have positive rating
implications, or conversely, the sale to a lower-rated entity and/or an
entity with a more aggressive operating strategy could have negative
rating implications. However, Fitch views ACAS's sale to a single buyer,
as the least likely outcome of the sale process, given the size and
complexity of the business.
Despite the Negative Watch, Fitch believes debtholders continue to be in
a solid position in terms of collateral coverage. Based on the
investment portfolio at Dec. 31, 2015, the currently outstanding secured
and unsecured notes could be fully repaid if the investment portfolio
was liquidated using an 90.2% haircut, assuming proceeds were used to
reduce borrowings. Should cash be used solely to fund share repurchases,
debtholders could be fully repaid if the portfolio was haircut 80.5%.
The ratings are supported by ACAS's relatively low leverage, modest oil
and gas exposure and sufficient liquidity to service near term debt
maturities. As a C corporation, ACAS can retain earnings, which is also
viewed favorably by Fitch.
Rating constraints include ACAS's, inconsistent operating strategy,
outsized equity exposure relative to peers, which is subject to more
valuation volatility, large levels of non-accruals and paid-in-kind
(PIK) interest income, limited funding flexibility, and an inability to
access the equity markets without severely diluting existing
shareholders.
In November 2015, Elliot Management Corp. (Elliot) filed a proxy urging
ACAS's shareholders to vote against the company's spin-off proposal,
citing that the plan to create a new BDC and standalone asset manager
would put the firm's assets at risk, serve to entrench management and
significantly limit options for future stockholder value creation.
Elliott holds an approximate 5% stake in ACAS, making it one of the
firm's largest shareholders.
On Nov. 25, 2015, ACAS announced that the board instructed the company
to undertake a full strategic review with its advisors, Goldman Sachs
and Credit Suisse, to consider alternatives to maximize shareholder
value including the possible sale of part or all of its business, or to
proceed with the previously announced spin-off plans. On Jan. 7, 2016,
the company completed the initial phase of its strategic review and
announced it would proceed with the solicitation of offers to purchase
the company or its various business lines in whole or in part.
The company did not provide further details on the potential timing of a
potential transaction, nor is Fitch aware of any specifics beyond those
outlined by the company in the public domain, but Fitch expects the
transformation will move relatively quickly to avoid damage to the
franchise and sponsor relationships, if the transaction cannot be
completed. That said; Fitch believes the transaction will be complicated
and it will be difficult finding a single buyer of ACAS's portfolio,
given the existing CLO exposure, its ownership of an asset manager,
publicly traded mortgage REITs, and legacy buyout equity investments.
Leverage, defined as total debt to total equity, amounted to 0.26x, as
of Dec. 31, 2015. Net of unrestricted balance sheet cash, leverage was
0.16x, which is among the lowest amongst peer-BDCs. However, Fitch
believes lower leverage is appropriate given ACAS's outsized exposure to
equity and CLO investments, which represented approximately 51%, or 38%
excluding ACAS's equity investment of American Capital Asset Management
(ACAM), of the total investment portfolio, as of Dec. 31, 2015.
During the fourth quarter of 2014, the board authorized the purchase of
$600 million to $1 billion of ACAS's common stock through June 20, 2016,
under a programmatic 10b5-1 share repurchase plan at prices per share
below 85% of the most recent quarterly NAV. During the year ended Dec.
31, 2015, ACAS repurchased a total of 36.9 million shares in the open
market for $525.6 million at an average price of $14.25 per share. Since
the inception of the share repurchase program in 2011, ACAS has
repurchased a total of 138.5 million shares, totaling $1.7 billion and
representing 40% of its outstanding shares, more than any other peer-BDC.
Fitch generally views share repurchases as shareholder friendly and a
contributor to higher leverage metrics, to the detriment of creditors.
Should ACAS repurchase shares up to the $1 billion program limit,
leverage would increase to 0.29x. However, if the earning accretion
achievable through the share buyback is greater than the accretion other
achievable through investments in new loans, creditors could benefit
from stronger cash flow coverage. More recently, ACAS has funded its
share repurchases through liquidation proceeds from its broadly
syndicated loan portfolio. Since investment activity has slowed and ACAS
is deleveraging its balance sheet, Fitch understands the motivation its
meaningful buybacks. However, if share repurchases inflate leverage
beyond levels commensurate with portfolio risk, this would be viewed
negatively by Fitch.
In Fitch's view, asset quality remains a key rating constraint, as
non-accrual loans remain elevated on an absolute and relative basis.
Non-accruals amounted to 10.6% of the portfolio at cost and 4.9% at fair
value, as of Dec. 31, 2015, compared to the peer average of 2.7% and
0.86% at cost and fair value, respectively. Overall, Fitch believes
asset quality metrics will be somewhat volatile going forward, as the
portfolio amortizes or liquidates and become adversely selected when
stronger borrowers refinance or repay, and weaker credits remain.
ACAS does not have meaningful exposure to oil and gas investments, which
is a benefit given the steep declines in energy prices since 2014. The
firm had $157 million of investments in oil, gas & consumable fuel and
energy equipment and services companies, representing 3.5% of the total
investment portfolio at cost, as of December 31, 2015. Fitch conducted a
stress test on ACAS's energy portfolio along with the peer group, and
views the impact of valuation declines and write-offs on leverage
metrics as negligible.
Adjusted after-tax net investment income (NII) amounted to $265 million
in 2015, up significantly from $136 million in 2014 driven by interest
and dividend income growth and advisory income generated by ACAS's
investment manager, American Capital Asset Management (ACAM). NII was
adjusted for severance costs of $19 million and $12 million in 2014 and
2015, respectively, related to ACAS's planned workforce reduction. Fitch
expects operating performance will decline modestly on an absolute
basis, due to a reduction in investment income resulting from portfolio
amortization and/or liquidation. Further cost reductions by ACAS may be
warranted in efforts to maintain current margins.
Currently, Fitch views ACAS's funding flexibility as being limited given
its reliance on secured debt and because its stock is trading at a
meaningful discount to NAV. Since the first quarter of 2010, ACAS's
shares have been trading at an average discount of 32.7%. Share
repurchases have been modestly accretive to NAV, totaling $2.66 per
share since the program began.
ACAS's liquidity profile is considered adequate, with $483 million of
balance sheet cash at year-end 2015 and $3.7 billion of proceeds from
principal repayments and investment sales in 2015. Given the outstanding
balance of $1.3 billion under its various debt facilities and remaining
authorization of up to $474.4 million in share repurchases, assuming no
further investment activities, Fitch believes ACAS has sufficient
liquidity to repay its debt in full prior to its scheduled maturities.
Generally, Fitch monitors non-cash income closely, as RIC regulations
require distributing 90% of taxable earnings on an annual basis.
However, ACAS does not currently qualify as a RIC and, therefore, is
able to retain earnings. Still, Fitch will continue to closely monitor
PIK levels relative to investment income, even though ACAS is not
expected to return to RIC status over the near-term. As of December 31,
2015, PIK as a percentage of total investment income amounted to 6.4%,
which is consistent with the peer average.
RATING SENSITIVITIES
IDRs AND SENIOR DEBT
Should ACAS sell its business to a lower-rated entity, and/or the
acquirer has a more aggressive operating strategy, that could drive
negative rating momentum. In a scenario where ACAS pursues a partial
sale, an orderly liquidation of its business or if the firm is unable to
sell its business, that could also be viewed negatively from a ratings
perspective, as it signals possible reputational or franchise damage.
Negative rating actions could also be driven by a material increase in
leverage not commensurate with the relative risk of the investment
portfolio, or resulting from significant unrealized portfolio
depreciation or outsized share repurchases, a spike in non-accrual
levels, and/or higher PIK income. An inability to redeploy portfolio
proceeds into attractive investment opportunities would also be viewed
unfavorably from a ratings perspective.
Fitch believes, over the near-term, positive rating momentum would only
be driven by the full sale of ACAS's business to a higher-rated acquirer
or acquirers.
If the Long-term IDR were to be downgraded, there is the potential for
the outstanding senior secured debt and unsecured debt ratings to stay
at their current level, subject to the assessment of ACAS's liquidity
profile and asset coverage at that time.
Based in Bethesda, MD, ACAS is a publicly traded private equity firm and
alternative asset manager organized in 1986 which completed its IPO in
1997. As of Dec. 31, 2015, the company managed $21 billion of assets,
including balance sheet assets and fee-earning assets under management
by affiliated managers with $73 billion of total assets under management.
Fitch has placed the following ratings on Rating Watch Negative:
American Capital, Ltd.
--Long-term IDR 'BB-';
--Senior secured debt 'BB+';
--Senior unsecured debt 'BB-'.
Date of Relevant Committee: March 8, 2016
Additional information is available on www.fitchratings.com
Applicable Criteria
Global Non-Bank Financial Institutions Rating Criteria (pub. 28 Apr 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=865351
Additional Disclosures
Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1000671
Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
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