American Capital Ltd. Has an Expense Problem

Like many of its BDC brethren, American Capital Ltd. has an expense problem. Its high operating costs continue to weigh on its earnings and likely drive its persistent discount to net asset value (book value).

Ever since bottoming out in 2009 at a fraction of book value, American Capital has traded at a significant discount to its book value per share. Today, shares trade at a 33% discount to its book value per share, one of the largest discounts in its industry.

What's driving the valuation?A common refrain among bulls is that American Capital is a complicated entity. It's true. Unlike most business development companies, it doesn't currently pay a dividend, and it has a far-flung European division, whereas its peers typically invest only in the United States. Not to mention, it's currently undergoing a maneuver whereby it will convert from an asset owner to an asset manager.

That's an intricate story, but the market has had years to make sense of it. And to date, American Capital's discount has been unwavering.

The real problem, as I see it, is one of compensation and expenses. As an internally managed BDC, the company's expenses appear directly on its income statement. Last quarter, American Capital paid $40 million in compensation, in addition to $15 million in additional general and administrative expenses. The combined tally -- $55 million -- consumed nearly 36% of its pre-tax operating income. That puts it among some of the least efficient of its peers.

Will things change?If we allow history to be our guide, it's my belief that the new American Capital will be just as "loose" with its expenses as the old American Capital. As a former shareholder, I've spent a long time tracking its history of rewarding executives handily while producing single-digit net operating income returns on equity for shareholders.

Take the company's history of share repurchases. From the third quarter of 2011 to the end of the first quarter of 2015, American Capital repurchased roughly 101 million shares of stock.However, its diluted share count fell by only 62.4 million shares. The difference is due to stock option compensation given to insiders.

Furthermore, one of the reasons for the delay in its spinoff plans, as I see it, is the fact that insiders have millions of options that would expire worthless if the spinoff were completed on a faster timeline. According to its first-quarter presentation, insiders will receive more than 1 million stock options in every quarter until the third quarter of 2016, at which point the rewards trickle off.

But going back even further to...say, the depths of the financial crisis, American Capital has rewarded insiders handsomely. After falling from more than $40 per share before the crisis to less than $1 per share at its depths, American Capital felt it necessary to compensate its employees hand over fist. In December 2009, when shares traded for a paltry price of $3, it offered its employees a $0.05 per option award to cancel their options at higher strike prices. Options were then graciously given to insiders at much lower strike prices, ensuring that they would receive lucrative stock-based compensation as the stock price recovered.

Shareholders are losing an important protectionBy law, BDCs cannot issue options equal to more than 20% of their shares outstanding. American Capital briefly addressed this on its second-quarter 2013 call when CEO Malon Wilkus said, "We have granted over many years all the options we are really able to grant because, as a BDC, we're limited to 20% of our shares to be under option. We may have a few miscellaneous options still available to grant, but it's really at insignificant levels."

When American Capital completes its spinoff and becomes an asset manager, shareholders will have to trust that this management team, which has historically granted itself options to the full extent it could, will show some restraint in how it compensates itself going forward.

Given past history, I'm not a believer that they can or will. The company's compensation was a problem when it was a BDC -- when it had actual limits on compensation enforced by law. As an asset manager, it will be free to reward options without limitation. Under its new structure, any options will be granted against the crown jewel of its portfolio: the asset manager.

Its persistent discount to net asset value isn't about its complicated structure, but its record of paying insiders handsomely. Unless that changes, I can't see why American Capital deserves to trade in line with peers, let alone at a premium to peer valuations.It's high time that the interests of the company's owners (the shareholders) take priority to the interests of its insiders.

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