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American Capital's Value Vexes Investors

The investment firm could see big markdowns now that the buyout boom has fizzled.

The recent private equity boom propelled assets of all kinds to record valuations. In that environment, investment firm

American Capital Strategies

(ACAS)

was a great stock to own.

Now things have changed.

The buyout boom is fizzling out. Asset values are depreciating because deals are being renegotiated and underwriting was too optimistic. Tougher credit markets are forcing deal volume to slow dramatically.

All these issues pose problems for American Capital, which through its investment business participates in buyouts of mostly privately held companies. The stock is now nicknamed "A-CRASH" by hedge fund short-sellers who believe the ticker "ACAS" is too polite for the upcoming carnage.

American Capital investors have seen impressive growth in recent years. The company's shares have outpaced the

S&P 500

on a total-return basis for nine of the past 10 years.

But in the first half of this year, the stock fell 4%, compared with a 7% increase in the S&P. Management has been telling investors recently that the stock is wildly cheap, at around $41, or 1.1 times book value, with a 9% dividend yield.

But bears say the stock faces much more trouble. They believe the company's investment portfolio is set to be marked down in value in coming quarters, which will hurt book value and create losses.

American Capital's impressive profit growth in recent years was fueled by its rapidly expanding asset base, which increased the amount of interest and dividend income the company received from its investments. This piece of the company's business represents about 75% to 80% of profits. The rest of the profits come from an asset management business.

The investment portfolio totaled $11.5 billion of "fair value" at the end of June, according to the company's balance sheet. That was up 64% from a year earlier.

This portfolio, however, is somewhat opaque. American Capital discloses its investment stakes -- which include various forms of debt and equity -- in each of its companies each quarter, but it never explains how the values are determined. The portfolio also includes commercial mortgage-backed securities and other collateralized debt securities.

Assets are revalued every quarter, with the last mark-to-market coming at the end of June -- before the acceleration of the credit crunch that is hurting buyout deals. But there is no breakdown about these portfolio companies' profits or which multiples are being used for the values.

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Since most of American Capital's investments are in private companies, the entire portfolio's value is even harder to grasp.

"We remain wary of the company's portfolio valuation (since there is no liquid market for its assets)," said Bank of America analyst Robert Lacoursiere in an early August research note, where he downgraded the stock from buy to neutral.

Skeptics say the investment portfolio may be subject to large writedowns in coming quarters in light of the revaluation of assets worldwide.

"American Capital aggressively collected assets during the market bubble and paid top dollar for CMBS, CLOs, leveraged loans for LBOs and equity investments in LBOs," says Brad Golding, managing director with Christofferson, Robb and Company, a bond firm that also manages a long/short equities fund. Golding's firm does not disclose its investment positions.

The issue is particularly of note since American Capital's asset values ballooned each quarter.

"Over the past 18 months, they further marked up these investments, taking over $850 million of unrealized gains into income," Golding says. "If they accurately mark their positions, they will not only see these gains evaporate but be forced to take further losses on investments. This will no doubt swing the company to a loss in the third quarter."

For its part, American Capital says that its portfolio is evaluated on an ongoing basis by advisory firm Houlihan Lokey Howard & Zukin. Houlihan sits in on the company's portfolio valuation decisions but only provides official opinions on a quarter of the investment portfolio each quarter, says Malon Wilkus, the CEO of American Capital. The entire portfolio is reviewed by Houlihan on an annual basis.

Wilkus says transaction multiples have not fallen for the buyout deals it looks at. For instance, he says the troubled buyout of

Home Depot's

(HD) - Get Report

supply unit, which stoked the market's concerns about debt financing, is a poor proxy for American Capital's portfolio since his firm focuses on middle-market companies.

"What is happening with these large companies where suddenly a huge set of buyers has disappeared has not necessarily happened to the middle market, where frankly there are a thousand middle-market private firms that have still got plenty of capital to buy companies," Wilkus says.

Nonetheless, he admits writedowns could be coming."There may very well be depreciation," Wilkus says. "We'll find out at the end of the quarter."

Not everyone is so optimistic.

"The entire book value is stale and is not based on anything other than Houlihan," which is paid by American Capital, says one hedge fund short-seller of the stock.

At the end of the day, values may ultimately be driven by the performance of the underlying companies in which American Capital invests. As one of the most prolific originators of debt and equity finance over the past few years, American Capital may have very well made some poor investments.

"We believe even with ACAS' due diligence, low closing ratio, and near average debt-to-EBITDA multiples, the sheer volume of asset origination increases the probability that some bad apples have slipped through the company's origination platform," said Jefferies & Co. analyst Richard Shane in a recent research note, in which he cut the stock from buy to neutral.