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) 📕

FIGURE 32.1 Total Value of ALD Insider Holdings Before and After OCP

Just like when the magician’s lovely lady assistant—having been sawed in half, smiles and moves her feet and hands to show all is well—the Allied insiders repeated their familiar sideshow pantomime: They showed their “confidence” in the stock through nominal open market purchases. The lady had, in fact, not been sawed in half! Walton, who had just received $14.5 million in cash (in addition to $14.5 million in stock) in the option tender, was the biggest “inside” purchaser by far, acquiring 50,000 shares for $1.1 million. The purchases received substantial media attention, including positive coverage from Bloomberg, Barron’s, The Motley Fool and Insiderscore.com. Within a couple of weeks the shares recovered to $25.47; Allied promptly sold a fresh 3.25 million shares in an overnight stock offering led by Deutsche Bank.

On September 30, 2007, Allied rated $3.93 billion of its $4.33 billion portfolio Grade 1 (capital gain expected) or Grade 2 (performing to plan). Allied classified only $401 million, or 9 percent, of its investments in Grades 3 through 5. Yet, as Table 32.1 shows, $1.35 billion, or 31 percent, of Allied’s portfolio were investments that had been performing below plan in that they had either been partially written down or were non-accruing.

Table 32.1 Written-down and/or Non-Accrual Investments

Allied classified several hundred million dollars of investments that had partial markdowns to be Grade 1 or Grade 2. How could investments in such a state be considered Grade 1 or Grade 2? Grade inflation. It appeared that if Allied considered a gain likely on its equity kicker, it classified the entire investment—loan and equity—as Grade 1. The converse was not true: If Allied expected the junior portion of an investment to generate a loss, it did not downgrade the entire investment, but only the impaired junior portion.

Some of Allied’s few remaining appreciated investments appeared questionable. As noted, with the sale of Mercury Air, Allied picked the last obvious flower in its portfolio. One of the largest unrealized gains left was Financial Pacific Company, a lessor of equipment to small businesses, which Allied bought in June 2004. Unlike most of Allied’s investments, there was abundant public data about Financial Pacific because it had filed documents with the SEC in anticipation of going public. Allied purchased it at a high price and a sizable premium to the anticipated public offering price. Allied paid $94 million—either three and a half times or five times Financial Pacific’s equity, depending on whether Financial Pacific retired its subordinated debt in the transaction. According to its SEC filing, the yield on the equipment leases was fixed, but Financial Pacific’s borrowings had variable rates. As a result, the filing warned that increases in short-term interest rates would have an adverse impact on the company. Almost immediately after Allied purchased the company, the Federal Reserve began a campaign of short-term interest rate increases. From July 2004 to August 2006 the Federal Reserve raised the overnight rate seventeen times from 1 percent to 5.25 percent. Despite Allied’s high initial purchase price and an interest rate headwind that had only recently begun to abate, as of September 30, 2007, Allied valued Financial Pacific at a sizable premium.

Callidus was another remaining unrealized gain. Allied bought a majority stake in Callidus (with Callidus management retaining a minority stake) in November 2003, concurrently committing to take large positions in the riskiest portions of Callidus’ future deals. Allied did not consolidate Callidus, because it considered Callidus to be a “portfolio company.” As we learned in our research about Allied’s accounting treatment of BLX, investment companies could consolidate their financials with other investment companies. On that basis, Callidus would be eligible for consolidation. The non-consolidation of Callidus enabled Allied to boost its earnings by recognizing unrealized appreciation on its investment in Callidus. If Allied consolidated Callidus, it could not book such gains (see Table 33.2).

Table 32.2 Written-up Investments

Allied now had limited ability to produce net investment income to sustain the distributions. Dramatically reducing Allied’s generation of recurring earnings were: lower portfolio interest yields, which had fallen from 14.3 percent in March 2002 to 11.9 percent in September 2007; reduced ability to recognize fees from controlled companies; and higher operating expenses, especially compensation. Net investment income, which almost covered the tax distribution in 2001, covered less than 30 percent of it in the first nine months of 2007. As a result, Allied adopted a capital gains strategy, fully dependent on selling winners and keeping losers.

Though Allied would do everything it could to avoid turning its unrealized losses into realized losses—especially at BLX given its slippery footing, the outcome might be beyond Allied’s control. In addition to its $190 million unrealized loss and $136 million remaining investment in BLX, Allied had a large exposure to the guarantees it made on BLX’s bank line. In September 2007, Allied agreed to increase its guarantee from 50 to 60 percent to enable BLX to obtain short-term waivers of its defaults until January 2008. In January 2008, it increased the guaranty on BLX’s bank line to 100 percent or $442 million. Should BLX implode and Allied make good on the guarantee, Allied’s realized loss could exceed $700 million, assuming that the government did not extract further restitution or penalties from Allied.

Allied had built up a large “kitty” of undistributed taxable earnings by selling its winners and keeping its losers. Allied assured its investors that this gave the company the long-term ability to make quarterly tax distributions. I believed it had become harder for Allied to find meaningful winners to harvest and the eventual losses from BLX would deplete, if not exceed, the kitty. Looking at Allied’s September 2007 valuations—without assuming additional losses at BLX, or for that matter other impacts from Allied’s aggressive accounting—Allied’s portfolio had $683 million of unrealized losses and only $283 million of unrealized gains.

All told, Allied had to distribute about $410 million per