OREANDA-NEWS. Fitch Ratings has placed the 'BB-' Long-term Issuer Default Rating (IDR), 'BB+' senior secured debt, and 'BB-' senior unsecured debt for American Capital, Ltd. (ACAS) on Rating Watch Negative. Today's rating actions are taken as part of Fitch's periodic review of Business Development Companies (BDCs), which encompasses 10 publicly rated firms.

BDC INDUSTRY OUTLOOK

Fitch's outlook for the BDC sector is negative; reflecting competitive underwriting conditions, earnings pressure, underperforming energy investments, unsustainable asset quality metrics, increased activist pressure, and limited access to growth capital. While some firms are better positioned, given their more conservative financial profiles and portfolio characteristics, others are likely to see rating pressure over the outlook horizon.

BDCs are heavily dependent on the equity markets to fund portfolio growth, but access to the market has been almost non-existent over the last 18 months as share prices continue to trade at steep discounts to net asset value (NAV). At March 7, 2016, rated BDCs were trading at a 18.3% average discount to NAV, thus preventing most from issuing stock without significantly diluting existing shareholders. While the reduction in portfolio growth is viewed favorably by Fitch, given tough underwriting conditions, some firms may struggle to close the trading gap, leaving them at a competitive disadvantage if and when investment opportunities arise.

The decline in commodity prices has yielded the first notable crack in asset quality performance for BDCs. More broadly, asset quality metrics remain at unsustainably low levels, in Fitch's opinion. While strong portfolio company performance has been supported by an improving economic environment, low interest rates are likely masking some potential underlying company-specific issues, as issuers have been able to refinance themselves out of trouble rather easily in recent years. Fitch believes asset quality metrics are likely to deteriorate over the near term; however, the pace of deterioration will be somewhat dependent upon the rate of change in interest rates, the backdrop of the broader economic environment, differing sector exposures, and the integrity of individual firms' underwriting.

Fitch has not observed a marked increase in leverage levels for the sector, with average leverage for investment grade-rated BDCs of 0.74x at year-end 2015 compared to 0.60x at year-end 2014. However, there is a wide dispersion of leverage around the average, and those with the most energy exposure often also have the highest leverage ratios. Share repurchase activity has also increased in the sector in recent quarters, which could inflate leverage ratios further. Fitch believes that BDCs heavily focused on maximizing leverage run the risk of having less dry powder to deploy when if and when underwriting conditions improve, thus weakening earnings upside.

KEY RATING DRIVERS

IDRs AND SENIOR DEBT

The Rating Watch Negative stems from potential changes in ACAS's strategy, organizational structure, and/or ownership over the near- to medium-term, which are more likely to translate into negative rating actions, in Fitch's opinion, given the complexity of the business model, relative to other BDCs. Currently, ACAS is soliciting bids for the sale of its business in whole, or in parts.

If ACAS should pursue a partial sale, an orderly liquidation of its business or if the firm is unable to sell its business, that could translate into negative rating action.

Should ACAS pursue a full sale of its business, Fitch would assess the credit worthiness of the potential acquirer or acquirers. All things equal, the sale to a higher-rated entity could have positive rating implications, or conversely, the sale to a lower-rated entity and/or an entity with a more aggressive operating strategy could have negative rating implications. However, Fitch views ACAS's sale to a single buyer, as the least likely outcome of the sale process, given the size and complexity of the business.

Despite the Negative Watch, Fitch believes debtholders continue to be in a solid position in terms of collateral coverage. Based on the investment portfolio at Dec. 31, 2015, the currently outstanding secured and unsecured notes could be fully repaid if the investment portfolio was liquidated using an 90.2% haircut, assuming proceeds were used to reduce borrowings. Should cash be used solely to fund share repurchases, debtholders could be fully repaid if the portfolio was haircut 80.5%.

The ratings are supported by ACAS's relatively low leverage, modest oil and gas exposure and sufficient liquidity to service near term debt maturities. As a C corporation, ACAS can retain earnings, which is also viewed favorably by Fitch.

Rating constraints include ACAS's, inconsistent operating strategy, outsized equity exposure relative to peers, which is subject to more valuation volatility, large levels of non-accruals and paid-in-kind (PIK) interest income, limited funding flexibility, and an inability to access the equity markets without severely diluting existing shareholders.

In November 2015, Elliot Management Corp. (Elliot) filed a proxy urging ACAS's shareholders to vote against the company's spin-off proposal, citing that the plan to create a new BDC and standalone asset manager would would put the firm's assets at risk, serve to entrench management and significantly limit options for future stockholder value creation. Elliott holds an approximate 5% stake in ACAS, making it one of the firm's largest shareholders.

On Nov. 25, 2015, ACAS announced that the board instructed the company to undertake a full strategic review with its advisors, Goldman Sachs and Credit Suisse, to consider alternatives to maximize shareholder value including the possible sale of part or all of its business, or to proceed with the previously announced spin-off plans. On Jan. 7, 2016, the company completed the initial phase of its strategic review and announced it would proceed with the solicitation of offers to purchase the company or its various business lines in whole or in part.

The company did not provide further details on the potential timing of a potential transaction, nor is Fitch aware of any specifics beyond those outlined by the company in the public domain, but Fitch expects the transformation will move relatively quickly to avoid damage to the franchise and sponsor relationships, if the transaction cannot be completed. That said; Fitch believes the transaction will be complicated and it will be difficult finding a single buyer of ACAS's portfolio, given the existing CLO exposure, its ownership of an asset manager, publicly traded mortgage REITs, and legacy buyout equity investments.

Leverage, defined as total debt to total equity, amounted to 0.26x, as of Dec. 31, 2015. Net of unrestricted balance sheet cash, leverage was 0.16x, which is among the lowest amongst peer-BDCs. However, Fitch believes lower leverage is appropriate given ACAS's outsized exposure to equity and CLO investments, which represented approximately 51%, or 38% excluding ACAS's equity investment of American Capital Asset Management (ACAM), of the total investment portfolio, as of Dec. 31, 2015.

During the fourth quarter of 2014, the board authorized the purchase of $600 million to $1 billion of ACAS's common stock through June 20, 2016, under a programmatic 10b5-1 share repurchase plan at prices per share below 85% of the most recent quarterly NAV. During the year ended Dec. 31, 2015, ACAS repurchased a total of 36.9 million shares in the open market for $525.6 million at an average price of $14.25 per share. Since the inception of the share repurchase program in 2011, ACAS has repurchased a total of 138.5 million shares, totaling $1.7 billion and representing 40% of its outstanding shares, more than any other peer-BDC.

Fitch generally views share repurchases as shareholder friendly and a contributor to higher leverage metrics, to the detriment of creditors. Should ACAS repurchase shares up to the $1 billion program limit, leverage would increase to 0.29x. However, if the earning accretion achievable through the share buyback is greater than the accretion other achievable through investments in new loans, creditors could benefit from stronger cash flow coverage. More recently, ACAS has funded its share repurchases through liquidation proceeds from its broadly syndicated loan portfolio. Since investment activity has slowed and ACAS is deleveraging its balance sheet, Fitch understands the motivation its meaningful buybacks. However, if share repurchases inflate leverage beyond levels commensurate with portfolio risk, this would be viewed negatively by Fitch.

In Fitch's view, asset quality remains a key rating constraint, as non-accrual loans remain elevated on an absolute and relative basis. Non-accruals amounted to 10.6% of the portfolio at cost and 4.9% at fair value, as of Dec. 31, 2015, compared to the peer average of 2.7% and 0.86% at cost and fair value, respectively. Overall, Fitch believes asset quality metrics will be somewhat volatile going forward, as the portfolio amortizes or liquidates and become adversely selected when stronger borrowers refinance or repay, and weaker credits remain.

ACAS does not have meaningful exposure to oil and gas investments, which is a benefit given the steep declines in energy prices since 2014. The firm had $157 million of investments in oil, gas & consumable fuel and energy equipment and services companies, representing 3.5% of the total investment portfolio at cost, as of December 31, 2015. Fitch conducted a stress test on ACAS's energy portfolio along with the peer group, and views the impact of valuation declines and write-offs on leverage metrics as negligible.

Adjusted after-tax net investment income (NII) amounted to $265 million in 2015, up significantly from $136 million in 2014 driven by interest and dividend income growth and advisory income generated by ACAS's investment manager, American Capital Asset Management (ACAM). NII was adjusted for severance costs of $19 million and $12 million in 2014 and 2015, respectively, related to ACAS's planned workforce reduction. Fitch expects operating performance will decline modestly on an absolute basis, due to a reduction in investment income resulting from portfolio amortization and/or liquidation. Further cost reductions by ACAS may be warranted in efforts to maintain current margins.

Currently, Fitch views ACAS's funding flexibility as being limited given its reliance on secured debt and because its stock is trading at a meaningful discount to NAV. Since the first quarter of 2010, ACAS's shares have been trading at an average discount of 32.7%. Share repurchases have been modestly accretive to NAV, totaling $2.66 per share since the program began.

ACAS's liquidity profile is considered adequate, with $483 million of balance sheet cash at year-end 2015 and $3.7 billion of proceeds from principal repayments and investment sales in 2015. Given the outstanding balance of $1.3 billion under its various debt facilities and remaining authorization of up to $474.4 million in share repurchases, assuming no further investment activities, Fitch believes ACAS has sufficient liquidity to repay its debt in full prior to its scheduled maturities.

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. Still, Fitch will continue to closely monitor PIK levels relative to investment income, even though ACAS is not expected to return to RIC status over the near-term. As of December 31, 2015, PIK as a percentage of total investment income amounted to 6.4%, which is consistent with the peer average.

RATING SENSITIVITIES

IDRs AND SENIOR DEBT

Should ACAS sell its business to a lower-rated entity, and/or the acquirer has a more aggressive operating strategy, that could drive negative rating momentum. In a scenario where ACAS pursues a partial sale, an orderly liquidation of its business or if the firm is unable to sell its business, that could also be viewed negatively from a ratings perspective, as it signals possible reputational or franchise damage.

Negative rating actions could also be driven by a material increase in leverage not commensurate with the relative risk of the investment portfolio, or resulting from significant unrealized portfolio depreciation or outsized share repurchases, a spike in non-accrual levels, and/or higher PIK income. An inability to redeploy portfolio proceeds into attractive investment opportunities would also be viewed unfavorably from a ratings perspective.

Fitch believes, over the near-term, positive rating momentum would only be driven by the full sale of ACAS's business to a higher-rated acquirer or acquirers.

If the Long-term IDR were to be downgraded, there is the potential for the outstanding senior secured debt and unsecured debt ratings to stay at their current level, subject to the assessment of ACAS's liquidity profile and asset coverage at that time.

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, 2015, the company managed $21 billion of assets, including balance sheet assets and fee-earning assets under management by affiliated managers with $73 billion of total assets under management.

Fitch has placed the following ratings on Rating Watch Negative:

American Capital, Ltd.
--Long-term IDR 'BB-';
--Senior secured debt 'BB+';
--Senior unsecured debt 'BB-'.