Fitch Affirms ACAS' Ratings at 'BB-'; Outlook Stable
These actions are being taken in conjunction with a broader industry review, which includes 10 business development companies (BDCs). For more commentary on the broader sector review, please see 'Fitch Takes Several Negative Rating Actions Following BDC Peer Review', available at 'www.fitchratings.com'.
KEY RATING DRIVERS
The ratings affirmations and Stable Outlook reflect ACAS' relatively low leverage, improved operating performance since the crisis and access to the capital markets at reasonable terms. As a C corporation, ACAS can retain earnings, which is also viewed positively.
Rating constraints include ACAS' current outsized equity exposure relative to peer BDCs, which can generate material unrealized depreciation on its investment portfolio, large but improving levels of non-accruals and PIK, and its limited funding flexibility and dependence on a recovery in portfolio valuations and the firm's stock price. The company's evolving business strategy and organizational structure also limit positive rating momentum at this time.
On Nov. 5, 2014, ACAS announced that its board of directors had unanimously approved a plan to split the company's businesses by transferring most of the firm's investment assets into two newly established BDCs and having ACAS continue to operate primarily in the asset management business, through American Capital Asset Management (ACAM). It is contemplated that ACAS will spin off the new BDCs to its shareholders, resulting in three, publicly traded companies. The BDCs are anticipated to qualify and elect to be taxed as registered investment companies (RICs) with the objective of paying market rate dividends. ACAS will continue to operate as a taxable C corporation, retaining any net operating losses that exist at the time of the spinoff.
In 2014, ACAM raised five new funds including, a new BDC (American Capital Senior Floating Rate) invested in senior floating rate loans and CLO equity; a private equity fund (American Capital Equity III) focused on the lower middle market; two CLOs (CLO 2014-1 and 2014-2); and a fund invested in senior and mezzanine debt (ECAS UK SME Debt) of small and medium sized enterprises in the United Kingdom. Subsequent to these investments, ACAS increased total earning assets under management at ACAM by 19% to \$14.5 billion as of Dec. 31, 2014 from \$12.6 billion, as of Dec. 31, 2013.
These actions continue to signal ACAS' strategic shift to focus on raising third-party funds for fee income, as opposed to direct on-balance sheet investments. Generally speaking, Fitch views less balance sheet intensive activities favorably, although the stability and diversity of the fee sources would also need to be considered.
During the 4Q14 earnings call, ACAS announced that it had consolidated European Capital Limited (ECAS) on balance sheet as part of the SEC's recent guidance on wholly-owned subsidiaries of BDCs where the operations are considered an extension of the firm's investment operations. The impact to net asset value (NAV) at ACAS was modest as the \$87 million of ECAS' unrealized appreciation is mostly offset by \$71 million of tax provisions due to the removal of a deferred tax asset previously recorded on ACAS' equity investment in ECAS.
In addition, ACAS announced during the 4Q14 earnings call that it continues to make progress with its advisors and regulators on the contemplated spinoff to help the firm separate its investment and asset management businesses in a legally-, regulatorily-, and tax-efficient manner. The company did not provide any further details on the timing, but Fitch expects the corporate transformation will likely occur in 2015, subject to certain conditions including shareholder and regulatory approvals, receipt of an opinion from its tax advisors, and the refinancing of ACAS' debt and the establishment of new credit facilities for the new BDCs.
Although underlying portfolio trends have improved markedly, asset quality remains a concern as non-accrual loans remain elevated and among the highest levels for BDCs. Non-accruals to 5.8% on a cost basis, at Dec. 31, 2014, down from 17.0% at Dec. 31, 2013. On a dollar basis, non-accruing loans at cost also improved to \$201 million from \$287 million during the same period. Inclusive of ECAS as of Dec. 31, 2014, non-accruals would have amounted to \$371 million at cost, representing 9.4% of total loans. The overall improvement in non-accruals was primarily driven by improved portfolio company performance, exits, and write-offs. Non-accruing loans were valued at 57.7% of cost (39.9% inclusive of ECAS), as of Dec. 31, 2014, which is ACAS' expected recovery rate on the investments and consistent with the firm's more mezzanine and equity focus. Fitch would view positively continued improvements in ACAS' overall asset quality metrics.
Direct exposure to oil, gas and consumable fuels represented 2.3% of the total investment portfolio, with an additional 0.3% of energy exposure derived from collateral held in CLOs, as of Dec. 31, 2014. The combined energy exposure of 2.6% is well below the peer average of 10.5%. Fitch conducted a stress test on the firm's energy exposure along with the rest of the peer group, and views the impact of valuation declines on the firm's leverage as negligible.
Leverage, as measured by debt-to-equity, amounted to 0.31x at Dec. 31, 2014, inclusive of the ECAS consolidation during 4Q14. ACAS' leverage is among the lowest of the BDCs, but Fitch believes it is appropriate given the company's outsized equity exposure. Leverage ticked up from 0.15x at Dec. 31, 2014 due to the use of revolver capacity to fund new investments in senior floating rate loans. As the firm continues to ramp-up additional assets for the spinoff, Fitch will evaluate leverage in the context of the increased leverage that may be applied to senior floating rate loans relative to the more conservative leverage that may be applied to junior investments.
Currently, Fitch views ACAS' funding flexibility as being limited given its corporate structure and depressed portfolio valuations and share price. However, Fitch views positively, ACAS' recent actions to obtain funding at economic terms. For example, in June 2014 and October 2014, the firm closed on a two-year, \$750 million and a two-year, \$500 million revolver through wholly-owned special purpose vehicles formed for the purpose of purchasing floating rate senior loans. Borrowings under the facilities bear interest at LIBOR plus 1.60% and are subject to borrowing base requirements. In March 2015, ACAS upsized the two-year facility by \$500 million to \$1.25 billion and the maturity was extended by two-years to March 2017.
ACAS' liquidity profile is considered adequate, with \$676 million of balance sheet cash and \$723 million under its revolving credit facilities, subject to borrowing base requirements, at Dec. 31, 2014. Cash flows from investment repayments and exits amounted to \$2.8 billion in 2014, an increase from \$1.4 billion in 2013. Net cash available to support new portfolio investments was \$2.8 billion in 2014, an increase from \$840 million in 2013.
Generally, Fitch monitors non-cash income closely, as RIC regulations require distributing 90% of taxable earnings on an annual basis. However, ACAS does not currently qualify as a RIC and, therefore, is able to retain earnings. Fitch will continue to closely monitor PIK levels relative to investment income, even though ACAS is not expected to return to RIC status.
RATING SENSITIVITIES
ACAS dropped its RIC status several years ago, and has more recently focused on raising third-party funds for fee income. The firm has also been funding new investments in anticipation of its plan to spin-off two new BDCs to shareholders with ACAM operating primarily in the asset management business. Fitch believes these actions signal a change in the company's strategy and/or organizational structure over the near- to medium-term. This could translate into rating action depending upon more clarity with respect to ACAS' ultimate strategy and structure, and importantly, where the rated debt resides.
In the intervening time until there is more clarity with respect to ACAS' end state, upward rating momentum is unlikely, but could potentially be driven by improved funding flexibility, increased unsecured debt and access to equity capital, stronger asset quality trends and a decline in the proportion of equity investments in the portfolio.
Conversely, interim negative rating action could be driven by a material increase in leverage, significant unrealized portfolio depreciation, a spike in non-accrual levels, and/or higher PIK income.
Based in Bethesda, MD, ACAS is a publicly traded private equity firm and alternative asset manager organized in 1986 which completed its IPO in 1997. As of Dec. 31, 2014, the company managed \$22 billion of assets, including balance sheet assets and fee-earning assets under management by affiliated managers with \$86 billion of total assets under management.
Fitch has affirmed the following ratings:
American Capital, Ltd.
--Long-term IDR at 'BB-';
--Senior secured debt at 'BB+';
--Senior unsecured debt at 'BB-'.
The Rating Outlook is Stable.
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