Rule Clouds American Capital

Private-equity concern American Capital Strategies Ltd. has been placing full value on various loans it has made even as other investors who hold the same debt already have slashed the values. Now, a new accounting rule governing the use of market values for financial assets could force American Capital to bring its valuations down, and that could lead to big write-downs. That could slam the publicly traded company's shares. The company holds nearly $6 billion of high-interest loans it has made to medium-size companies, typically as part of leveraged-buyout transactions. The new rule, Statement of Financial Accounting Standards No. 157, which took effect in January, changes the way companies think about placing market values on assets that don't have hard prices. In a note Friday, Stifel Nicolaus analyst Troy Ward said the introduction of the accounting rule would likely have more impact on American Capital's asset valuations than on those of its peers. Under the new rule, companies will have to place greater emphasis on what someone else would pay for that asset if it were sold today. By contrast, until the end of last year, American Capital based the value of many of its investments on internal models and original transaction costs. The company started to apply the new rule in its first quarter. Financial results for the period are scheduled to be released Wednesday. Any write-downs in the quarter may be larger than even bearish analysts have predicted. That is because the values American Capital attached to many of its loans before the first quarter were considerably higher than values ascribed by other investment companies, according to company filings. American Capital declined to comment on specifics of its valuations, pointing to disclosures in its 2007 annual report. Shares in American Capital are flat for the year, in line with indexes that track financial companies. In 4 p.m. Nasdaq Stock Market trading Friday, the shares were down 57 cents, or 1.8%, to $32.01. Because of the way it is structured, American Capital pays out most of its profit as dividends, giving it one of the most attractive dividend yields in the Standard & Poor's 500-stock index. The company forecasts it will pay out a $4.19 per-share dividend this year, giving the stock a 13.1% forward yield. But in recent months, the company's balance sheet has become the focus for analysts, many of whom believe the midsize companies American Capital has invested in will experience hard times in a slower-growing economy. "Investors aren't appreciating the credit risk in the company's balance sheet right now," says Daniel Furtado, analyst at Jefferies & Co. who rates the company a sell. The slower-growing economy, along with reduced investor demand for leveraged loans, has caused the prices of many of American Capital's loans, many of which are inactively traded, to drop. The new accounting rule, with its emphasis on sale prices, could force American Capital to write down the value of its loans so those values are more in line with values posted by its peers. These valuation gaps aren't small. At the end of last year, American Capital valued an $18.6 million loan to insurer AmWINS Group Inc. at 100 cents on the dollar. That loan was trading at 80 cents on the dollar on Dec. 31, 2007, according to price data from Reuters Loan Pricing. At the end of November, the Eaton Vance Floating-Rate Income Trust valued that AmWINS loan at slightly less than 86 cents on the dollar. By the end of December, the Morgan Stanley Prime Income Trust valued a loan to AmWINS that matures a year earlier at 85 cents on the dollar. In fact, 11 companies show up in the debt-holding lists of both the Morgan Stanley fund and American Capital. In each case, at the end of last year, Morgan Stanley valued its loans lower than did American Capital, even in cases where the Morgan Stanley loan matured first. The biggest difference was in a loan for a household-products company, KIK Custom Products. The Morgan Stanley fund valued its KIK debt at just less than 70 cents on the dollar at the end of last year. American Capital gave its debt full value. Friday, the market price for KIK's loan was 35 cents on the dollar, according to Reuters Loan Pricing.