Demystifying Those Rarely Impaired BDCS

Editor's note: This column is a special bonus for RealMoney subscribers written by Mark Haefele, who writes daily on the RealMoney Pro site. Haefele is chief financial officer and chief operating officer of Sonic Capital and serves as co-manager for a Boston-based hedge fund. This piece appeared on RealMoney Pro Monday, Aug. 12. To sign up for RealMoney Pro, where you can see Haefele's commentary on a daily basis, click here.

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For months now, some of the sharpest minds on Wall Street have accused Business Development Companies of improperly valuing their portfolio assets, using equity offerings to fund excessive dividend payouts and being overvalued in comparison to closed-end funds or publicly traded venture funds.

Hedge fund manager Greenlight Capital has already released a detailed and intelligent examination of Allied Capital (ALD - commentary - Cramer's Take) and its accounting. Neither Allied's response, nor its conference calls, nor its investor conference (which I attended) addressed the substance of Greenlight's claim. But another BDC, American Capital Strategies (ACAS - commentary - Cramer's Take), provides further insight into methods BDCs use in their operations.

Required Rates of Return

The crux of the bear argument is that American cannot fund its dividend, now yielding over 10%, from its core business of lending to middle-market companies. To make up the shortfall between what the operations bring in and what the company pays out, the critics contend the company issues new equity at a premium to book value. Indeed, the following chart shows that cash flows from operations have increasingly trailed the ever-rising dividend burden. In recent quarters, operating cash flows are less than half of the dividends paid out.

From Whence Does the Dividend Come?

Source: Company Reports

Management disputes this characterization with a slide that proclaims "Dividends Are Paid From Cash Flows, Not Capital Raises." It turns out that management considers principal repayment of their loans a source of cash flow and even provides a stylized example of how this is supposed to work. In their example, return of principal allows American to both pay its dividend and maintain its investment portfolio. The reality, however, is much different. If XYZ Corp has $100 to lend and is in the business of making one-year 5% loans, XYZ Corp can only safely pay a $5 annual dividend. If XYZ Corp regularly pays out $10 annually, its lending capacity is diminished, and so too its ability to fund future dividends. Claiming $105 in "cash flow" does not change this underlying reality.

Stylized examples aside, the stark reality is that for years, American has been paying more in dividends than it makes in profits. Only through frequent new equity offerings at a premium has American been able to keep its book value from declining precipitously. We estimated what the book value per share would be without the contribution of new equity raises for the past 2 1/2 years. That is, we re-calculated the book value by adding the actual earnings and subtracting the actual dividends, but without adding the contribution of new stock sales. This analysis is very generous, as we gave American the full earnings benefit of the new equity, which also funds newer vintage loans (it takes time for credit quality to deteriorate). Without the benefit of new issuances, the book value would have declined by 29% over this span instead of 7%.

Thus, there is no support for management's contention that new equity is not used to fund the dividend. One might wonder why no sell-side analyst has blown the whistle on such an unsustainable business model. A review of the banks that have done recent underwriting for American will quickly reveal that there are no objective sell-side analysts covering this company. They all work for firms with an investment banking relationship to American.

Portfolio Valuation Tricks

Some sell-side analysts have noted that American seems to be more diligent about writing down portfolio losses on a quarterly basis, when compared to other BDCs. We consulted a sharp-eyed independent analyst not conflicted by investment banking. He points out that, in two recent cases, American wrote down only a small portion of their investments in portfolio companies entering bankruptcy, and American was quick to write these investments back up again when they bought pieces of these firms out of bankruptcy. The analyst, who prefers to remain anonymous, points out that these transactions raise the question of whether American is throwing good money after bad in order to avoid realizing losses.

As Biddeford Textiles headed toward bankruptcy earlier this year, American took an unrealized $1.1 million loss on warrants representing 10% of the equity it owned. American did not, however, write down the value of its $2.5 million in senior debt. Instead, the slides from a recent investor presentation seem to indicate that American kicked in another $600,000 at bankruptcy to take over 100% of the successor company, Biddeford Real Estate Holdings, which holds the manufacturing facility and real estate.

American rolled the cost basis of its equity and debt into the successor company, so Biddeford Real Estate now has $3.6 million debt (the original $2.5 million debt plus the original $1.1 million equity). In the second quarter of 2002, American recorded a $1.1 million appreciation in the old company, which matches perfectly the previous write-down.

In the larger case of Decorative Surfaces International's bankruptcy, American had previously taken $5.3 million in unrealized losses on the equity, but did not write down $18.4 million of DSI's subordinated debt that it was carrying on its books. Rather, American invested another $13.7 million to buy 100% of the successor company, American Decorative Services. Again, the new company that emerged assumed the old company's debts to American, including the value of American's equity. Thus, American Decorative Services owes $24 million in subordinated debt to American. In the second quarter of 2002, American recorded a $5.3 million appreciation in the old company, again matching the previous writedown. In the restructuring, American bought only one of DSI's two facilities, so although American increased its total exposure to the company, the asset base and revenue potential have declined. Additionally, with American kicking in almost $14 million, LaSalle National Bank was willing to loan the new American Decorative Surfaces $14.3 million, which is senior to American's debt.

In both of these portfolio "exits," American claims an annualized return of 18%. Not only did American claim to have salvaged its debt value completely in these companies, it also claims to have salvaged all its equity value, a remarkable feat in a bankruptcy workout. However, the related-party nature of these transactions gives one pause. Consider that American is now carrying $3.6 million Biddeford Real Estate debt and $24 million American Decorative Services debt on the asset side of its ledger. The corresponding liabilities are held by each company, respectively. These debts are not consolidated, even though American owns 100% of these companies.

With further investments in bankrupt portfolio companies, American is, at best, increasingly levering itself to an economic recovery and, at worst, covering up bad investments by throwing in new money. Yet one thing is certain. As these examples show, American is far from conservative in the valuation of its portfolio assets.

Capital.com

American created Capital.com in December 1999. First Union (now Wachovia), a frequent banker to American, bought a 15% stake for $15 million. Based on this transaction, American justified a write-up of its remaining 85% stake.

As of Dec. 31, 1999, the company valued its Capital.com stake at $72.5 million, even though in the real world it is unlikely American could have disposed of its investment at that level. The Capital.com markup constituted essentially all of American's earnings for the fourth quarter of 1999.

This write-up of a majority stake in a month-old company based on a small investment by a friendly outsider shows the considerable discretion American and other BDCs have in valuing their portfolio assets.

On Oct. 31, 2000, after Capital.com had been in business for less than a year, American announced that the Capital.com stake was depreciated back to its $1.5 million cost. This writedown blew a hole in American's earnings for the third quarter of 2000 but was partially offset by write-ups taken in other portfolio companies, especially o2wireless Solutions (OTWO - commentary - Cramer's Take), which managed to go public at $12 a share. o2wireless now trades at 20 cents.

If the cases of Biddeford and American Decorative Surfaces, where American pushed failed investments off its balance sheet, is reminiscent of what Enron did with its Raptor vehicles, the investment in Capital.com displays an accounting adventure that can best be compared to Enron's shenanigans in broadband, Braveheart -- the codename of the fanciful accounting Enron used to show big gains from a video-on-demand partnership with Blockbuster, just months after creating the partnership.

Market Verdict

After the manifold accounting scandals that have shocked investors and destabilized markets, market participants have developed a far healthier skepticism toward stocks in general. While opaque accounting and seemingly unsustainable business models keep the BDCs under fire from some of the smartest professionals on the Street, their stock prices remain remarkably expensive. With a valuation that is still 50% above the supposed book value, short interest in American has tripled in the past two months, as many investment pros continue to bet there are further declines to come.

Short Interest

In a Lake Wobegon world, "where all the children are above average," the BDCs' children -- their portfolio companies -- are rarely impaired, even in bankruptcy. Cash flows can be insufficient, but made up by raising new equity. Debts to oneself show up in the asset side of the ledger but not the liability side. But as increasing scrutiny bears down on this previously little-known market niche, investors find small comfort in what little disclosure the firms provide.

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As originally published, this story contained an error. Please see Corrections and Clarifications.

Mark Haefele is chief financial officer and chief operating officer of Sonic Capital and serves as co-manager for a Boston-based hedge fund. At the time of publication, Haefele was short ACAS, although positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell, hold or short any security. Haefele holds a Ph.D. in History from Harvard University, Master's degrees in History from Harvard and the Australian National University, where he was a Fulbright Scholar, and a Bachelor's degree in History from Princeton University.