It's no wonder the topic of valuation got a lot of play at

American Capital's

(ACAS)

annual investor day last week. The investment company continues to use some of the most questionable valuation methodologies in the public markets.

And it's why American Capital remains popular with short-sellers, with 15% of the stock sold short.

One of those short-sellers over the past year has been Greenlight Capital, headed by respected value investor David Einhorn, according to a person familiar with his thinking. Einhorn could not be reached for comment.

Einhorn wrote about his ongoing battles with another business development company he is shorting,

Allied Capital

(ALD)

, in his new book

Fooling Some of the People All of the Time

.

Both Allied Capital and American Capital, which invest mostly in private companies, have been criticized by investors for using aggressive valuation methodologies.

Questioning Valuation

Most of American Capital's investments -- which include equity and debt investments in companies, along with various types of collateralized securities -- are considered Level 3 assets under FAS 157 fair value accounting, which means they are mark-to-model assets. This allows management to have a considerable amount of control over the valuations.

One example is the firm's investment in

Scientific Protein Laboratories

, a company that manufacturers key ingredients used for heparin, a blood thinner. Scientific Protein Labs has been identified as the seller of ingredients used in

Baxter International's

( BXL) batch of heparin that has been linked to 81 deaths in the U.S. this year.

American Capital's investment in Scientific Protein Labs (referred to as SPL Acquisition in regulatory filings) had a fair value of $176 million on American Capital's balance sheet at the end of 2007. The valuation dropped to $141 million at the end of the first quarter, as American Capital wrote down the value of its preferred-stock investment from $41 million to $10 million. (The news story on the bad heparin broke in the first quarter).

But the firm's $131 million debt investment in SPL was essentially left untouched.

At American Capital's annual investor day last week, one audience member questioned the valuation of Scientific Protein.

"I'm trying to understand, as we're trying to get comfortable with valuations through the portfolio, how the debt of a company that is looking at lawsuits that could probably bankrupt it if even a fraction of them come to fruition, how that can possibly be marked at par?" the unidentified audience member asked a panel of American Capital officials, according to a webcast replay of the event.

American Capital CEO Malon Wilkus, who was in the audience and not on the panel, immediately grabbed the microphone from the questioner, according to an investor who attended the event.

Wilkus said the situation was very sad, but he called Scientific Protein a "very good company ... and we think it will do extremely well," according to the webcast.

He did point out that Scientific Protein had some insurance to cover itself from lawsuits but stopped short of saying how much.

"I think that is about all we can say about the company specifically," he said.

Wilkus eventually concluded the discussion by saying, "Getting down to the details of what is happening inside the company, with 170 companies in the portfolio, just generally doesn't make much sense for us."

And therein lies the rub with American Capital: You don't really know what's under the hood.

Breaking Down Profit Performance

This uncertainty is a problem given that the firm's earnings quality has weakened of late.

American Capital in early May reported an $813 million loss in its first quarter. The results were weighed down by $997 million of accounting markdowns. But even adding back those paper losses and adjusting for other items, the company reported negative operating cash flow of $10 million.

The company reported net operating income of $151 million from its portfolio investments, but 38% of that was from non-cash accrued interest income on payment-in-kind (PIK) interest and dividend payments to the company. PIK income generally results from financially strapped borrowers paying interest with more debt rather than cash.

Another hot topic surrounding American Capital is the control premium the company is applying to its majority interest in

European Capital

, a public company on the London Stock Exchange whose stock price has plummeted over the past year.

American Capital has avoided marking the full stock-price loss on its balance sheet since the firm applies a large control premium on top of the market-based loss of the investment.

In a

November 2007 column

, I raised the issue about how this control premium conflicts with FAS 157, unless American Capital is arguing for what would be a very aggressive interpretation of the rule. In a subsequent talk with Wilkus, the firm's CEO, I asked him to specifically correct sections of my article that were wrong, since he objected so vehemently to it. I never heard back from him on this issue.

American Capital officials did not return emails and calls seeking comment for this article.

The control premium was the subject of much discussion at the investor day. At one point, an American Capital official said the

Securities and Exchange Commission

was behind the curve on FAS 157. Nonetheless, the company also said that the control premium issue was posed to the SEC, which blessed the use of it -- by essentially not objecting to it.

"If they objected to it, they wouldn't have approved it for the first quarter," an official said. At this point, American Capital and its accountants are still working through the FAS 157 language. A few months from now, it wouldn't be surprising if the control premium disappears and American Capital is forced to value this investment like the disappointment it is.

Even if American Capital can get away with all these aggressive valuations, the company is starting to fool fewer and fewer investors.

Just 45% of American Capital's stock is owned by institutions -- which means it has a very heavy retail investor base, which is not a positive. Less than 1% of the stock is held by insiders.

Retail investors continue to chase a very high-dividend yield, now at 12.5%, while their principal investment -- the price of the stock -- has fallen 35% from its 52-week high.

I'd stay clear of this dog. These days, the smart money in this stock is in the short trade.

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