Buy Sign From American Capital Strategies?

Investors who consider buyout firms to be smart money have a growing array of ways to emulate their moves—beyond just investing in their limited partnerships.

They can invest in shares or bonds of the dozens of public companies with financial sponsors behind them; they can buy shares in publicly-traded funds of funds that back buyout shops; or they can buy shares directly in publicly traded alternative asset managers, such as American Capital Strategies or The Blackstone Group.

Here’s another way. Scour the latest financial statements of those same publicly traded alternative asset managers, expected to be joined soon by Apollo Management, and Kohlberg Kravis Roberts & Co. Home in on their unrealized write-downs. Then sniff for signs—a giant billboard, in at least one case—that the buyout firm feels that the assets are undervalued.

For the six months ended June 30, American Capital Strategies reported net unrealized depreciation of $1.3 billion on a total portfolio valued at $9.7 billion. The portfolio includes investments in senior debt, subordinated debt, and equity in the buyouts of private companies, as well as investments in structured products—collateralized mortgage-backed securities, collateralized loan obligation securities, and collateralized debt obligation securities.

Needless to say, that net unrealized depreciation accounted for a big chunk of the net loss of $883 million, or $4.42 per diluted share, posted by American Capital Strategies for the first six months of the year. Displeased investors have sent the value of those shares down more than 33 percent year-to-date as of press time.

But in discussing results in its latest 10q, filed in mid-August, American Capital Strategies said that, in general, “…the credit quality of our portfolio remains good considering that we may likely be in a recession.” The firm pointed in particular to its structured products investments. The firm has written down the value of those assets by $314 million in the first six months of the year (between a write-down of $360 million in the first quarter and a write-up of $46 million in the second).

Then comes the giant billboard: “As we currently expect to hold these structured products investments to settlement or maturity, we do not expect to realize a loss on most of the current or prior period unrealized depreciation as we anticipate the future proceeds to be received upon settlement or maturity to exceed the GAAP fair value as of June 30, 2008 by approximately $476 million.”

My takeaway: American Capital Strategies believes that the fair value of those investments—or what the firm would get for the assets by selling today—understates the true value by up to $476 million.

Responding by e-mail to questions about the issue, Jay Beam, senior vice president on the financial analysis and compliance team at American Capital Strategies, wrote that this March, the Securities and Exchange Commission gave companies the green light to discuss certain hard-to-price assets in which they believe the fair value differs significantly from the value they expect to eventually realize.

Under accounting rule FAS 157, Beam wrote, the firm is “required to reflect” the value of the structured product investments “as if we were to sell them today” at a time when buyers “would require a higher IRR than what we originally underwrote, therefore [resulting] in the unrealized depreciation in fair value.” However, he added: “This unrealized depreciation will ultimately reverse itself as unrealized appreciation in future quarters if the underlying cash flows continue to perform as underwritten and we hold the investments until maturity or settlement.”

A buy signal for structured products? Or perhaps a reason to consider American Capital Strategies itself a buy? I’ll leave that for the smart money to decide.