Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New by David Einhorn (tohfa e dulha read online TXT) 📕

4, 2007, Sweet Traditions, a Krispy Kreme franchisee in Illinois, Indiana, and Missouri, filed for bankruptcy. In August 2006, Allied led a recapitalization of the then already ailing company. The bankruptcy documents indicated Sweet Traditions generated no operating profit and paid only about $275,000 to Allied in the year before the filing, about a tenth of the stated annual interest on the loan. According to Allied’s SEC documents, filed just weeks before the bankruptcy, Allied recognized $1.7 million of interest in 2006 and over $1 million in the March 2007 quarter before putting Sweet Traditions on non-accrual in the June 2007 quarter, while also continuing to value its entire $37 million investment in the debt and equity at cost. Déjà vu.

Allied announced its third-quarter 2007 results on November 7, 2007. For the first time in years it reported a loss of sixty-two cents per share. Following a multi-year boom in lending, risky bonds and loans had declined in value across the board. On the previous quarter’s conference call, management had downplayed the impact that the market decline would have on its $4 billion portfolio, but described the turn in the credit cycle as a positive development because Allied could make future loans at improved yields. As the credit crisis spread, however, valuation multiples contracted and Allied took write-downs “particularly in the financial services sector or from portfolio company circumstances that are not significant business model issues,” according to Walton. Having harvested most of its winning investments, Allied did not have offsetting write-ups this time.

Net investment income was also poor at only twelve cents per share, after a nine-cent-per-share cost from the tender offer for insider options, which had been completed in July at $31.75 per share. Income taxes that Allied paid the government for the privilege of deferring tax distributions an additional year cost seven cents per share. Allied closed its sale of Mercury Air, and, in a blast from the past, finally recognized a realized loss in its investment in Startec Global Communications.

Walton led off the quarterly conference call by describing the results as “mixed.” Then came the surprise: BLX will “significantly de-emphasize government-guaranteed lending going forward.” BLX’s cost structure and capital requirements had become “sub-optimal.” BLX would focus on non-government guaranteed “conventional” small business lending. The result would be a 30 percent short-term reduction in originations and a write-down of BLX’s residual interests and book value leading to an additional $84 million write-down of Allied’s investment, which contributed to the loss in the quarter.

Walton continued, “To effect this change in strategy, Bob Tannenhauser, BLX’s current CEO, will take on the role of Chairman for an interim period, and John Scheurer, who has successfully built two commercial mortgage loan investment businesses for Allied Capital, will step into the role of interim CEO.” I immediately wondered whether Allied was concerned Tannenhauser might be indicted and wanted to be able to call him a “former employee” if that inconvenience came to pass.

No matter how ugly BLX appeared, Allied just kept applying rouge. To give up would cause not just a write-down, but also a realized loss. A realized loss the size of BLX would count against Allied’s kitty of undistributed tax distributions that Allied stored to give investors “visibility” into future “dividends.” Instead, Allied decided to re-focus BLX. “We believe that there is significant opportunities [sic] to build and grow BLX as a conventional small business and commercial real estate lender. John is actively working to add commercial mortgage industry veterans to expand BLX’s commercial real estate platform. We think John is the right guy to lead BLX through this change in strategy and we have the record and resources to support the company through this transition,” Walton explained. If it made sense to have Scheurer create a new commercial mortgage-lending platform, it would certainly be easier to build one from scratch, rather than on top of BLX’s mess—high cost of capital, and all.

In the Q&A session, the sell-side analysts were already trying to figure out how to spin the lousy result. Henry Coffey of Ferris, Baker & Watts offered, “If we were to throw GAAP out the window, which is something I would be happy to sponsor, Joan, what—would it be fair to, when we’re looking at your operating earnings, to exclude the excise tax as well as some of the stock option expense and then what about the IPA [Individual Performance Award] charge?”

Even with the write-downs, it remained clear that Allied had not fully reflected the changed market conditions in its valuations. On the conference call, management acknowledged that credit spreads had widened. As they failed to do in 2002, Allied did not revalue its entire debt portfolio to take into account the deteriorating market conditions. The write-downs Allied took were concentrated in its equity positions; the debt investments generally remained at cost. Déjà vu, again.

Even after the Sweet Traditions bankruptcy, Allied still valued its non-accruing loan at cost—although this quarter it wrote-down its equity investment. Through its investment in the Callidus Capital Corporation, an asset management company, Allied had invested in a series of structured finance products, including the equity pieces of collateralized loan obligations (CLOs). The market values of structured finance vehicles had fallen especially hard in the developing crisis. However, Allied wrote-down the value of its $188 million of CLOs by only 6 percent.

Allied shares, which stood at $31.75 in June when the company priced the tender offer for the insider options, had weakened coming into the third-quarter announcement. In response to the bad news, the shares fell sharply to a low of $21.55 on November 8, 2007. Insiders had just received $53 million in cash and 1.7 million shares of stock in exchange for 10.3 million options with a weighted average exercise price of $21.50. Had Allied delayed the option tender until the company announced this bad news, the insider options would have had little value left. This “extra” $106 million for insiders equated to about three-quarters of a year’s worth