Fighting to stay above water

Business development company American Capital has defaulted on its debt, but Christopher Witkowsky finds it is battling hard to stave off bankruptcy

American Capital has had a rough ride recently, but its founder and chief executive, who has a significant amount of wealth invested in the company, believes the firm can weather the storm.

During a recent earnings call, Malon Wilkus said the business development company was working to shore up its capital base and find ways to stave off a bankruptcy filing, despite defaulting on $2.3 billion in debt.

“As you know, we have about $2.6 billion of GAAP net worth. We believe on a realisable basis it's about $1.9 billion higher than that,” Wilkus said during the call.

“As long as we have that positive book value, we believe we can protect the value for our shareholders even if we're having to seek protection under Chapter 11. A lot of it has to do with the fact that our creditors are unsecured. If they were secured, it would be much more difficult for me to come to that same conclusion.”

The firm, which went public in 1997, originates, underwrites and manages investments in mid-market private equity, leveraged finance, real estate and structured products. As a business development company, American Capital is governed by a set of rules under the Investment Company Act of 1940.

American Capital, like other buyout firms, expanded quickly during the peak economic climate of the past few years, buying up more portfolio companies than most of its rivals. Since 1997, the firm has invested in 223 portfolio companies.

The firm lost $3.1 billion in 2008, including $1.5 billion depreciation on the value of portfolio company investments. It narrowed its losses in the first quarter of this year to $547 million, compared with $813 million in the same quarter of 2008. Its unrealised losses on investments stood at $525 million in the first quarter this year, with $79 million in realised losses on investments.

One major restriction on business development companies that has come into play during the down-market is that they are prevented from issuing any debt without having asset coverage of at least 200 percent.

American Capital violated a covenant governing its coverage ratio, thus freezing its existing lines of credit and blocking the company from getting new credit. This is preventing the company from making new investments – the company's investment activity has all but stopped over the past six months or so.

“In effect, you cannot incur more debt until you effectively correct that violation,” says Scott Valentin, an analyst who covers American Capital for real estate investment trust Friedman Billings Ramsey.

To counter this, the company has been selling off assets, closing offices and laying off staff to shore up its capital base. American Capital recently acquired its European affiliate, European Capital, in an all-stock deal.

American Capital expanded quickly at the top of the market, Valentin says, and may have an issue with the quality of the companies it acquired in the heady days of the buyout boom.

“The biggest business development companies have attracted a lot of attention. They grew rapidly at the top of the market, and there are concerns about the quality they built,” Valentin says.

Lenders probably won't force American Capital into bankruptcy despite the debt defaults, Valentin says, because fire sales of portfolio companies in this environment will garner only distressed prices, which is not in anyone's best interests.

“Most of these companies are worth more alive than dead,” Valentin says about American Capital's portfolio companies. “This is not a good market for distressed assets, so you'd be selling assets at a low price. Lenders might be better off granting covenant waivers and allow the company to manage the portfolio and maximise cash flow that way.”

American Capital will ask its shareholders to approve reverse stock splits, which would help artificially boost the company's share price, especially if the price per share drops below $1, which would put it in violation of a Nasdaq minimum threshold requirement.

Kohlberg Kravis Roberts (KKR) has extended the deadline for its proposed merger with Euronextlisted vehicle KKR Private Equity Investors, known as KPE, to 31 August. The global firm intended to delist KPE prior to listing KKR in its entirety on the New York Stock Exchange, but has re-evaluated its plan amid the current recession.

Venture capital firm BlueRun Ventures has closed its fourth fund, BRV IV, on just under $250 million, shy of its original target of $300 million. The firm decided to stop fundraising because of adverse market conditions, although it said it could potentially raise more capital for the fund in future.

The Oregon Investment Council has drafted a set of principles it will use when considering future investments, including asking GPs to reduce management fees and take carry only after all capital is returned to limited partners (see p. 42). A spokesperson stressed the guidelines are not meant to be policy the council would be forced to abide by for each investment.

New York State Common Retirement Fund (CRF) has banned the use of placement agents, following allegations that sham finder fees were collected from investment firms for commitments from the pension (see p. 27). New York City Comptroller William Thompson asked trustees of the five city pensions, which combined have total assets of about $83 billion, to approve a ban on placement agents as well.

The Los Angeles City Employees' Retirement Fund (LACERS) and the New Mexico State Investment Council (SIC) have mandated that investment firms looking for commitments reveal the identity of any third-party marketers, following a pay-for-play scandal involving the New York State Common Retirement Fund. The New Mexico SIC suspended Aldus Equity because of the firm's involvement in the scandal.

Abbott Capital Management has raised more than $1 billion for its sixth fund of funds, Abbott Capital Private Equity Fund VI, which will invest in a mix of venture capital, growth equity, buyout and special situations funds in both the US and other developed markets. The firm's previous vehicle closed on $805 million in 2005.

Morgan Stanley has raised $1.14 billion for its fourth fund of funds, a 15 percent increase over its third fund of funds, which closed on $1 billion in 2006. The fund, Morgan Stanley Private Markets Fund IV, targets buyout funds based in North America and Western Europe, global venture funds and global special situations funds.

Turnaround specialist Alvarez & Marsal has launched a specialist private equity practice and is bringing in 30 “seasoned” professionals to work with GPs with struggling portfolio companies. Alvarez will be working with companies that are in early stages of distressed situations, rather than on the brink of bankruptcy.

Steve Moseley, president of private equity advisor StepStone Group, has resigned following media reports connecting him to recent accusations of sham finder's fees being paid to the New York State Common Retirement Fund. Moseley's reported connection to the case is through a co-investment vehicle that his previous firm PCG Capital Partners launched in 2006, while StepStone is not charged or named in the recent complaints.

The $11.5 bi l l ion Kentucky Retirement System, which is facing a “severe unfunded liabilities situation”, has committed $50 million to Commerce Street Income Partners Fund II to take advantage of debt trading at distressed prices. The pension hopes the debt opportunity will be a way to add income to the fund, which is in a negative cash flow situation.