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ACAS > SEC Filings for ACAS > Form 10-K on 3-Mar-2014All Recent SEC Filings

Show all filings for AMERICAN CAPITAL, LTD

Form 10-K for AMERICAN CAPITAL, LTD


3-Mar-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (in millions, except per share data)

Forward-Looking Statements

All statements contained herein that are not historical facts including, but not limited to, statements regarding anticipated activity are forward looking in nature and involve a number of risks and uncertainties. Actual results may differ materially. Among the factors that could cause actual results to differ materially are the following: (i) changes in the economic conditions in which we operate negatively impacting our financial resources; (ii) certain of our competitors have greater financial resources than us, reducing the number of suitable investment opportunities offered to us or reducing the yield necessary to consummate the investment; (iii) there is uncertainty regarding the value of our privately-held securities that require our good faith estimate of fair value, and a change in estimate could affect our NAV; (iv) our investments in securities of privately-held companies may be illiquid, which could affect our ability to realize the investment; (v) our portfolio companies could default on their loans or provide no returns on our investments, which could affect our operating results; (vi) we use external financing to fund our business, which may not always be available; (vii) our ability to retain key management personnel; (viii) an economic downturn or recession could impair our portfolio companies and therefore harm our operating results; (ix) our borrowing arrangements impose certain restrictions; (x) changes in interest rates may affect our cost of capital and NOI; (xi) we cannot incur additional indebtedness unless immediately after a debt issuance we maintain an asset coverage of at least 200%, or equal to or greater than our asset coverage prior to such issuance, which may affect returns to our shareholder; (xii) our common stock price may be volatile; and (xiii) general business and economic conditions and other risk factors described in our reports filed from time to time with the SEC. For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, please see the information under the caption "Risk Factors" described in this Annual Report on Form 10-K. We caution readers not to place undue reliance on any such forward-looking statements, which are made pursuant to the Private Securities Litigation Reform Act of 1995 and, as such, speak only as of the date made.

American Capital Investing Activity

We primarily invest in senior and mezzanine debt and equity of middle market companies, which we generally consider to be companies with revenue between $10 million and $750 million. Currently, we will invest up to $500 million in a single middle market company in North America. We also have investments in Structured Products, including CLO, CDO and CMBS securities and invest in funds managed by us.

We seek to be a long-term partner with our portfolio companies. As a long-term partner, we will invest capital in a portfolio company subsequent to our initial investment if we believe that it can achieve appropriate returns for our investment. Add-on financings to our portfolio companies fund (i) strategic acquisitions by a portfolio company of either a complete business or specific lines of a business that are related to the portfolio company's business,
(ii) recapitalization of a portfolio company to raise financing on better terms, buyout one or several owners or to pay a dividend, (iii) growth of the portfolio company such as product development or plant expansions, or (iv) working capital for a portfolio company, sometimes in distressed situations, that needs capital to fund operating costs, debt service or growth in receivables or inventory.

The total fair value of our investment portfolio was $5.1 billion, $5.3 billion and $5.1 billion as of December 31, 2013, 2012 and 2011, respectively. Our new investments totaled $1,107 million, $719 million and $317 million during the years ended December 31, 2013, 2012 and 2011, respectively.


Table of Contents

The aggregate dollar amount of new investments by type, use and business line were as follows (in millions):

Type                   2013      2012     2011
 Senior Debt         $   614    $ 417    $ 184
 Mezzanine Debt            -       56       57
 Preferred Equity        125       87       15
 Common Equity           236      150       60
 Structured Products     132        9        1
    Total by type    $ 1,107    $ 719    $ 317



Use                                                            2013        2012       2011
Investments in ACAM and Fund Development                     $   271     $  121     $   51
Sponsor Finance Investments                                      125        109         25
Structured Products                                               75          4          -
American Capital One Stop Buyouts®                                27        301          1
European Capital                                                   -         50         97
Direct and Other Investments                                       -          -         15
Add-on financing for acquisitions                                391         19         58
Add-on financing for recapitalizations, not including
distressed investments                                           104         71         27
Add-on financing for growth and working capital                   56         22          4
Add-on financing for working capital in distressed
situations                                                        42         22         35
Add-on financing for purchase of debt of a portfolio company      16          -          4
    Total by use                                             $ 1,107     $  719     $  317



Business Line                              2013      2012     2011
American Capital One Stop Buyouts®       $   503    $ 351    $  25
Investments in ACAM and Fund Development     271      121       51
Sponsor Finance Investments                  239      162      123
Structured Products                           75        4        -
Direct and Other Investments                  19       31       21
European Capital                               -       50       97
    Total by business line               $ 1,107    $ 719    $ 317

The amounts of our new investments include both funded commitments and unfunded commitments as of the investment date.


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We received cash proceeds from realizations and repayments of portfolio investments by source and business line as follows (in millions):

Source                                                       2013       2012       2011
Principal prepayments                                      $   604    $   938    $   510
Equity investments                                             362        274        394
Payment of accrued PIK notes and dividend and accreted OID     187        242        108
Scheduled principal amortization                                41         41         38
Loan syndications and sales                                     14          3         16
Total by source                                            $ 1,208    $ 1,498    $ 1,066



Business Line                        2013       2012       2011
American Capital One Stop Buyouts® $   530    $   927    $   597
Sponsor Finance Investments            410        320        379
European Capital                       195          -          -
Direct and Other Investments            34        208         49
Structured Products                     27         28         22
Asset Management                        12         15         19
Total by business line             $ 1,208    $ 1,498    $ 1,066

Operating revenue by business line was as follows (in millions):

Business Line                                  2013     2012     2011
American Capital One Stop Buyouts®            $ 145    $ 336    $ 318
Asset Management                                133      107       53
Sponsor Finance Investments                     111      104      120
Structured Products                              72       67       56
Direct and Other Investments                     20       26       40
European Capital                                  6        6        4
     Total operating revenue by business line $ 487    $ 646    $ 591


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Results of Operations

The following analysis of our financial condition and results of operations should be read in conjunction with our audited consolidated financial statements included in this Annual Report on Form 10-K and the notes thereto.

Our consolidated financial performance, as reflected in our consolidated statements of operations, is composed of the following three primary elements:

•        The first element is "NOI," which is primarily the interest, dividends,
         prepayment fees, finance and transaction fees and portfolio company
         management fees earned from investing in debt and equity securities and
         the fees we earn from fund asset management, less our operating expenses
         and provision or benefit for income taxes.


•        The second element is "Net realized gain (loss)," which reflects the
         difference between the proceeds from an exit of an investment and the
         cost at which the investment was carried on our consolidated balance
         sheets and periodic interest settlements and termination receipts or
         payments on derivatives, foreign currency transaction gains or losses
         and taxes on realized gains or losses.


•        The third element is "Net unrealized appreciation (depreciation)," which
         is the net change in the estimated fair value of our portfolio
         investments and of our interest rate derivatives at the end of the
         period compared with their estimated fair values at the beginning of the
         period or their stated costs, as appropriate, and taxes on unrealized
         gains or losses. In addition, our net unrealized depreciation includes
         the foreign currency translation from converting the cost basis of our
         assets and liabilities denominated in a foreign currency to the U.S.
         dollar.

The consolidated operating results were as follows (in millions):

                                            2013       2012       2011
Operating revenue                          $ 487     $   646     $ 591
Operating expenses                           255         263       288
NOI before income taxes                      232         383       303
Tax (provision) benefit                      (76 )        14       145
NOI                                          156         397       448
Loss on extinguishment of debt, net of tax     -          (3 )       -
Net realized loss, net of tax                (55 )      (270 )    (310 )
Net realized earnings                        101         124       138
Net unrealized appreciation, net of tax       83       1,012       836
Net earnings                               $ 184     $ 1,136     $ 974

Operating Revenue

We derive the majority of our operating revenue by investing in senior and
mezzanine debt and equity of middle market companies with attractive current
yields and/or potential for equity appreciation and realized gains. We also
derive operating revenue from investing in Structured Products and in our
wholly-owned portfolio company, ACAM. Operating revenue consisted of the
following (in millions):
                                                          2013     2012     2011
Interest income on debt investments                      $ 209    $ 274    $ 350
Interest income on Structured Products investments          72       67       56
Dividend income on private finance portfolio investments    36      161      106
Dividend income from ACAM                                  105       83       30
Other interest income                                        1        1        1
Interest and dividend income                               423      586      543
Portfolio company advisory and administrative fees          17       16       14
Advisory and administrative services - ACAM                 26       20       20
Other fees                                                  21       24       14
Fee income                                                  64       60       48
     Total operating revenue                             $ 487    $ 646    $ 591


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Interest and Dividend Income

The following table summarizes selected data for our debt, Structured Products
and equity investments outstanding, at cost (dollars in millions):
                                                              2013        2012        2011
Debt investments at cost(1)                                 $ 1,821     $ 2,302     $ 3,198
Average non-accrual debt investments at cost(2)             $   302     $   361     $   574
Effective interest rate on debt investments                    11.5 %      11.9 %      11.0 %
Effective interest rate on debt investments, excluding
non-accrual prior period adjustments                           10.7 %      11.7 %      10.9 %
Structured Products investments at cost(1)                  $   370     $   414     $   547
Effective interest rate on Structured Products investments     19.4 %      16.2 %      10.3 %
Debt and Structured Products investments at cost(1)         $ 2,191     $ 2,716     $ 3,745
Effective interest rate on debt and Structured Products
investments                                                    12.8 %      12.6 %      10.9 %
Average daily one-month LIBOR                                   0.2 %       0.2 %       0.2 %
Equity investments - private finance portfolio at
cost(1)(3)                                                  $ 2,025     $ 2,101     $ 2,228
Effective dividend yield on equity investments - private
finance portfolio(3)                                            1.8 %       7.5 %       4.7 %
Effective dividend yield on equity investments - private
finance portfolio, excluding non-accrual prior period
adjustments(3)                                                  4.1 %       5.7 %       3.1 %
Debt, Structured Products and equity investments at
cost(1)(3)                                                  $ 4,216     $ 4,817     $ 5,973
Effective yield on debt, Structured Products and equity
investments(3)                                                  7.5 %      10.4 %       8.6 %
Effective yield on debt, Structured Products and equity
investments, excluding non-accrual prior period
adjustments(3)                                                  8.3 %       9.5 %       7.9 %


 ----------
(1) Monthly weighted average of investments at cost.

(2) Quarterly average of investments at cost.

(3) Excludes our equity investment in ACAM and European Capital.

Debt Investments

Interest income on debt investments decreased by $65 million, or 24%, for the year ended December 31, 2013 over the comparable period in 2012, and by $76 million, or 22%, for the year ended December 31, 2012 over the comparable period in 2011, primarily due to the decrease in our monthly weighted average debt investments outstanding. Our weighted average debt investments outstanding decreased by $481 million for the year ended December 31, 2013 over the comparable period in 2012, and by $896 million for the year ended December 31, 2012 over the comparable period in 2011, primarily as a result of the repayment or sale of debt investments. In addition, the average non-accrual debt investments outstanding decreased from $361 million during 2012 to $302 million during 2013.

When a debt investment is placed on non-accrual, we may record reserves on uncollected PIK interest income recorded in prior periods as a reduction of interest income in the current period. Conversely, when a debt investment is removed from non-accrual, we may record interest income in the current period on prior period uncollected PIK interest income which was reserved in prior periods. For the years ended December 31, 2013, 2012 and 2011, we recorded additional interest income on uncollected PIK interest income recorded in prior periods of $14 million, $6 million and $2 million, respectively, as a result of debt investments being removed from non-accrual, which had an approximately 80 basis point, 20 basis point and 10 basis point positive impact, respectively, on the effective interest rate on debt investments.


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Structured Products

Interest income on Structured Products investments increased by $5 million, or 7%, for the year ended December 31, 2013 over the comparable period in 2012, and by $11 million, or 20%, for the year ended December 31, 2012 over the comparable period in 2011, primarily due to higher actual and projected payments on our CLO investments. Our weighted average Structured Products investments outstanding decreased by $44 million, or 10.6%, for the year ended December 31, 2013 over the comparable period in 2012, and by $133 million, or 24%, for the year ended December 31, 2012 over the comparable period in 2011, primarily as a result of the write-off of non-performing CMBS investments.

See Note 2-Interest and Dividend Income Recognition policy to our audited consolidated financial statements included in this Annual Report on Form 10-K for a description of how projected cash flows affect revenue recognition on our Structured Products investments.

Equity Investments - Private Finance Portfolio

Dividend income on private finance portfolio investments decreased by $125 million, or 78%, for the year ended December 31, 2013 over the comparable period in 2012 due to the following:

• for the year ended December 31, 2013, we recorded reserves on accrued PIK dividend income recorded in prior periods from preferred stock investments of $46 million; however, for the year ended December 31, 2012, we recorded dividend income for the reversal of reserves of accrued dividend income attributable to prior periods from private finance preferred stock investments of $37 million;

• for the year ended December 31, 2013, we recorded $16 million of dividend income for non-recurring dividends on common equity investments compared to $36 million for the year ended December 31, 2012; and

• a decrease of $73 million in the cost basis of accruing equity investments as of December 31, 2013 compared to December 31, 2012.

As a result, the monthly weighted average effective dividend yield on equity investments was 1.8% for the year ended December 31, 2013, a 570 basis point decrease over the comparable period in 2012.

Dividend income on private finance portfolio investments increased by $55 million, or 52%, for the year ended December 31, 2012 over the comparable period in 2011 primarily due to both an improvement in preferred equity investments that were previously non-accruing and an increase in non-recurring dividends on equity investments. As a result, the monthly weighted average effective dividend yield on equity investments was 7.5% for the year ended December 31, 2012, a 280 basis point increase over the comparable period in 2011.

When a preferred equity investment is placed on non-accrual, we may record net reserves on uncollected accrued dividend income recorded in prior periods as a reduction of dividend income in the current period. Conversely, when a preferred equity investment is removed from non-accrual, we may record dividend income in the current period for prior period uncollected accrued dividend income which was reserved in prior periods. For the year ended December 31, 2013, we recorded reserves on accrued PIK dividend income recorded in prior periods from preferred stock investments of $46 million which had an approximate 230 basis points negative impact on the effective dividend yield on equity investments. For the years ended December 31, 2012 and 2011, we recorded dividend income for the reversal of reserves of accrued dividend income attributable to prior periods from private finance preferred stock investments of $37 million and $36 million, respectively, which had an approximate 180 basis point and 160 basis point positive impact, respectively, on the effective dividend yield on equity investments.

For the years ended December 31, 2013, 2012 and 2011, we recorded $16 million, $36 million and $7 million, respectively, of dividend income for non-recurring dividends on common equity investments.

Equity Investments - ACAM

Dividend income from ACAM was $105 million and $83 million for the years ended December 31, 2013 and 2012, respectively. The increase in dividends received during the year ended December 31, 2013 was primarily due to an increase in fees earned for the management of AGNC and MTGE, both of which experienced growth as a result of follow-on equity offerings partially offset by share repurchases and realized losses, as well as fees earned for the management of ACAS CLO 2013-1 and ACAS CLO 2013-2.

Dividend income from ACAM was $83 million and $30 million for the years ended December 31, 2012 and 2011, respectively. The increase in dividends received during the year ended December 31, 2012 was primarily due to an increase in the net income of ACAM, which was primarily generated by an increase in fees earned for the management of AGNC and MTGE, both of which experienced significant growth in their equity capital as a result of follow-on equity offerings in 2012 and 2011.


Table of Contents

For the years ended December 31, 2013, 2012 and 2011, we received an additional $6 million, $9 million and $11 million, respectively, of dividends from ACAM which were recorded as a reduction to the cost basis of our investment in ACAM.

Fee Income

Portfolio Company Advisory and Administrative Fees

As a BDC, we are required by law to make significant managerial assistance available to most of our portfolio companies. This generally includes providing guidance and counsel concerning the management, operations and business objectives and policies of the portfolio company to its management and board of directors, including participating on the company's board of directors. Our portfolio company advisory and administrative fees for the years ended December 31, 2013, 2012 and 2011 were $17 million, $16 million and $14 million, respectively.

Advisory and Administrative Services - ACAM

We have entered into service agreements with ACAM to provide additional asset management and administrative service support so that ACAM can fulfill its responsibilities under its management agreements. The fees generated from these service agreements for the years ended December 31, 2013, 2012 and 2011 were $26 million, $20 million and $20 million, respectively. The fees generated from these service agreements increased $6 million, or 30%, for the year ended December 31, 2013 over the comparable periods in 2012 and 2011 due to an increase in the funds under management of ACAM, primarily ACAS CLO 2012-1, ACAS CLO 2013-1 and ACAS CLO 2013-2.

Other Fees

Other fees are primarily composed of transaction fees for structuring, financing and executing middle market portfolio transactions, which may not be recurring in nature. These fees amounted to $21 million, $24 million and $14 million, for the years ended December 31, 2013, 2012 and 2011, respectively.

Operating Expenses

Operating expenses decreased by $8 million, or 3%, for the year ended
December 31, 2013 over the comparable period in 2012 and by $25 million, or 9%,
for the year ended December 31, 2012 over the comparable period in 2011.
Operating expenses consisted of the following (in millions):
                                                 2013     2012     2011
Interest                                        $  44    $  59    $  90
Salaries, benefits and stock-based compensation   156      148      143
General and administrative                         55       56       55
Total operating expenses                        $ 255    $ 263    $ 288

Interest

Interest expense for the year ended December 31, 2013 decreased $15 million, or 25%, over the comparable period in 2012. The decrease in interest expense was primarily attributable to a decrease in the weighted average interest rate on outstanding public and private borrowings for the year ended December 31, 2013 over the comparable period in 2012 as a result of our debt refinancing in August 2012 and the continued paydown of our asset securitizations.

Interest expense for the year ended December 31, 2012 decreased $31 million, or 34%, over the comparable period in 2011. The decrease in interest expense was primarily attributable to a decrease in the weighted average interest rate and weighted average borrowings on outstanding public and private borrowings for the year ended December 31, 2012 over the comparable period in 2011 as well as a decrease in the amortization of deferred financing costs primarily as a result of unscheduled payments on our secured borrowings during 2011.


Table of Contents

The components of interest expense, cash paid for interest expense, average interest rates and average outstanding balances for our borrowings are as follows (dollars in millions):

                                                            2013       2012        2011
Asset Securitizations:
Cash interest expense                                     $    1     $     5     $     8
Amortization of deferred financing costs                       1           3           3
Total interest expense                                    $    2     $     8     $    11

Weighted average interest rate, including amortization of
deferred financing costs                                     3.6 %       2.0 %       1.3 %
Weighted average interest rate, excluding amortization of
deferred financing costs                                     1.4 %       1.3 %       0.9 %
Weighted average balance outstanding                      $   47     $   371     $   915

Public and Private Borrowings:
Cash interest expense                                     $   36     $    43     $    59
Amortization of deferred financing costs                       6           8          20
Total interest expense                                    $   42     $    51     $    79

Weighted average interest rate, including amortization of
deferred financing costs                                     6.6 %       8.7 %      10.6 %
Weighted average interest rate, excluding amortization of
deferred financing costs                                     5.6 %       7.3 %       7.9 %
Weighted average balance outstanding                      $  647     $   589     $   747

Total Borrowings:
. . .
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