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American Capital Strategies


appears to be using aggressive accounting to delay a large writedown in its portfolio of investments.

The most surprising piece of the company's earnings release this week was the firm's valuation of its investment in

European Capital

, a publicly traded London-based stock that fell 18% in the quarter.

This stock drop should have resulted in at least a $140 million loss for American Capital. Instead, it somehow translated into a $2 million gain.

Investors and analysts have been puzzled ever since.

reported in August that certain investors and analysts have criticized the methods used by American Capital to value its many investments, which range from publicly traded stock and debt securities to private investments.

The valuation of European Capital, however, might be the most perplexing move to date.

The latest issue centers around FAS No. 157, a new accounting standard issued by the Financial Accounting Standards Board last year. The rule governs how companies should determine the fair value of assets and financial instruments.

The FAS 157 accounting standard gives companies a hierarchy of "fair value" inputs to determine the way assets should be valued on balance sheets. Level I inputs are quoted prices of identical securities in active markets. Level II inputs are essentially comparable investments that may or may not be publicly traded. Level III inputs are unobservable inputs; essentially this is a valuation based on a financial model.

Last month, the Center for Audit Quality issued a white paper on FAS 157. The report states: "If the market is considered active, even if transaction volumes are lower than in the past, FAS 157 states that the quoted price (a "Level I input") provides the most reliable evidence of fair value and shall be used to measure fair value whenever available. The use of Level II or Level III inputs is generally not permitted when Level I inputs are available."

European Capital, which went public on the London Stock Exchange earlier this year, trades under the symbol ECAS. It was a spinoff from American Capital.

American Capital owns 70.8 million shares of ECAS, or a 65% stake. For American Capital's third quarter, ECAS shares fell 18% from about EUR10.58 to EUR8.66. During this same period, the euro rose 5.4% vs. the U.S. dollar.

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Thus, using the prices of the shares and currencies under a Level I valuation, American Capital should have booked some sort of loss on the ECAS investment -- and analysts calculate it should be at least $140 million.



! American Capital said its investment in ECAS


$2 million because it added a "control premium" to the valuation of the investment.

In essence, the company is arguing that its ECAS investment is worth more than the stock market says it is simply because American Capital owns a lot of the stock and could liquidate ECAS if it wanted in order to achieve some higher net asset value.

In a research note published Wednesday morning, Bank of America analyst Robert Lacoursiere flagged this latest issue at American Capital.

"Curiously, the ECAS investment was written up by $2mm after foreign currency translation, which implies the adoption of a $141.5mm (Euro 100mm) control premium," he wrote, adding that the "arrangement was puzzling."

On its earnings call Wednesday, American Capital management said the ECAS valuation method was allowed under FAS 157. "The methodology is price times quantity ... plus a control premium," management said.

But American Capital made no mention of the fact that the company may lose its ability to apply this control premium to the ECAS value in six months, as

has learned from conversations with FAS 157 experts. Furthermore, using a "control premium" in the first place is an example of very aggressive accounting.

American Capital did not return several emails and phone messages from

seeking clarification.

Sources at the Financial Accounting Standards Board say companies that own stock of another firm should nearly always base the valuation of the stock on the Level I formula: price of stock multiplied by quantity owned. Level I prohibits adding control premiums, the FASB sources say.

If you own stock in another public company, there are only two ways to get around the Level I valuation, say the sources, who have been privy to discussions by the FASB about FAS 157. FASB declined to comment.

One exemption is that the stock investment is considered to be "inactively traded." But if the stock is traded on a public exchange, such as ECAS on the London Stock Exchange, this exemption typically cannot be applied, the sources say.

The other exemption from Level I valuation is that the publicly traded stock is somehow not an identical version of the stock owned by the firm conducting the valuation. One way the stock might not be identical is if it is considered to be "restricted stock," the sources say.

This second exemption may in fact apply to American Capital's investment in ECAS, even though the company made no mention of it to investors on the call. According to the May prospectus from the ECAS initial public offering, American Capital has agreed to a lockup period of not selling its ECAS shares for 12 months.

However, being in a lockup period for an IPO doesn't automatically allow you to declare your stock as being "restrictive" and apply looser Level II valuations, the accounting sources say. Technically, American Capital owns common stock. The company restricted itself from trading the securities by signing the lockup agreement.

Nonetheless, it appears American Capital decided to head to Level II valuations. Why? Because "control premiums" are not allowed under Level I calculations, the sources say, thus preventing American Capital from bumping up the investment's value, as it could with Level II.

The important thing for investors to remember is that this "restrictive stock" exemption will likely fly out the window next May when the IPO lockup ends. At that point, American Capital will be forced into recording the ECAS investment under Level I methods, which prevent control premiums.

That means if ECAS shares stay where they are or fall further, American Capital could be facing at least $140 million in losses on its income statement in the future.

Another issue altogether is whether a control premium is even justified. Some finance and accounting academics argue that restricted stock is worth less than common stock and deserves a discount because of its illiquidity. So does the control premium offset the restricted stock discount? Hard to say.

Whether this is overly aggressive accounting is a question best left for auditors. But the reality is that the company's economic loss may simply have been delayed due to the peculiarity of accounting rules.