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BDC M&A

Jun. 01, 2016 12:58 PM ETACAS, ZAIRTX, BX, FIG-OLD, APO3 Comments
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Ares (ARES) announced a deal to acquire American Capital (ACAS) for $3.4 billion. American Capital has a very interesting history. They are the second largest business development company/BDC, trailing only Ares. ACAS has consistently traded at a discount to book value. A discount to book value is never a good sign for a history of good business decisions, but for an asset manager it means the market is valuing them at less than liquidation. The market either thinks they are overvaluing their assets or that management will destroy value (or both). Part of the reason for this discount is ACAS was the only major BDC that did not pay a dividend.

ACAS was going to pursue an extremely complex spinoff to reduce that discount. It was the first of its kind. Due to the complexity, the nature of the spin was constantly changing. It started as one spinoff, then went to two and back to one. Activist Elliott Management acquired a big stake last year. Elliott argued the spin was simply too complex and a way to entrench and overpaid management team. They pushed for a sale instead. ACAS immediately caved and began exploring a sale.

At the announcement, the Ares deal valued ACAS at $17.40 per share which was 0.85x book value. Elliott's average purchase price was about $13.30 per share, so this deal is a nice win for them and other shareholders who owned the stock during that period. Still, the outcome is a disappointment for shareholders. A bunch of big finance companies, including Blackstone (BX), Apollo (APO), and Fortress (FIG), were looking at making bids. Generally, when a bunch of people look at a target, the ultimate deal would be at a higher price than 0.85x book. Elliott had argued in November that ACAS could be worth more than $23 per share to a buyer.

Why were so many companies interested in American Capital? Ares and ACAS are both BDCs that lend money to smaller and middle market companies. Big banks are increasingly pulling back from lending to small and middle market companies due to regulatory requirements, so there is some opportunity for these guys. With a merger, they can exploit the benefits to scale including a lower cost of capital, and leveraged IT and investment professionals. To borrowers, size is helpful. The combined ARES/ACAS will be a larger company that can serve as a one stop shop for lending money. For example, a private equity company might need a $100 million loan to buy a $200 million company. If they have to go to four different people for $25 million checks, it increases complexity, fees, and the time to complete the deal. Those companies that need to go to the syndication market individually. There is unnecessary and redundant costs in this model; Ares will persuasively argue that their increased size makes it easier to fund deals. It will be easier to fund deals which will mean bigger underwriting and distribution fees. Few companies lend money and keep it all on their balance sheet; instead they will sell pieces of it to investors.

Is there opportunity here? The announced value of the deal was $17.40 per share. Some of that is in Ares stock, so the current consideration is around $17.23. But ACAS shares trade at $16.08, which means that this deal still has a relatively big spread. Why? It is extremely complex consideration - stock, cash from two different sources plus more cash contingent on sale less the cost of insurance, make up dividends, and fee waivers. There is some regulatory risk, but nothing too serious. Both sets of shareholders need to approve the deal. It is unlikely there's trouble here in getting the deal done. Want to learn more about BDC M&A? If you are interested, then please listen in on our discussion.

Analyst's Disclosure: I am/we are long ACAS.

Chris DeMuth Jr and Andrew Walker are portfolio managers at Rangeley Capital. We invest with a margin of safety by buying securities at discounts to their intrinsic value and unlocking that value through corporate events. To maximize returns for our investors, we reserve the right to make investment decisions regarding any security without notification except where notification is required by law. We manage diversified portfolios with a multi-year time horizon. Positions disclosed in articles may vary in sizing, hedges, and place within the capital structure. Disclosed ideas are related to a specific price, value, and time. If any of these attributes change, then the position might change (and probably will).

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