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) 📕

a couple of other successful shorts. One was Sirrom Capital, named for the founder, but with his surname spelled backwards. Sirrom was in the same business as Allied Capital, with which we were unfamiliar at the time. Sirrom was a business development company (BDC) making mezzanine loans (senior to equity, but subordinate to senior debt) to private companies.

BDCs are a special creation, formed by Congress as a way for small businesses to have more access to capital and receive professional management expertise. They have existed in some form since the Investment Company Act of 1940, but their current structure was born through Congress with the Small Business Investment Incentive Act of 1980. BDCs lend small businesses money, advise them, and in return collect interest and fees. In essence, BDCs are publicly traded private-equity firms that give the public an opportunity to participate in the growth of young companies. BDCs raise capital in equity offerings and act like closed-end mutual funds. They are subject to the Sarbanes-Oxley Act of 2002 and the Securities Exchange Act of 1934. BDCs are required to maintain 200 percent asset coverage on the debt they issue. In other words, the value of the assets they invest in must be twice the amount of debt they take on, which caps their ability to leverage. They also don’t pay corporate taxes, provided they pass through their taxable earnings directly to shareholders.

Sirrom funded rapid growth through a virtuous cycle where it raised equity at a sizable premium to net asset value (book value), which increased its net asset value and provided fresh, cheap capital to grow its portfolio. This cycle enabled Sirrom to grow its earnings and dividends, which caused the stock price to appreciate further, allowing Sirrom to repeat the cycle beginning with another stock offering.

As an investment company (a BDC is a type of regulated investment company), Sirrom did not report or consolidate the results of its underlying investments. Instead, Sirrom marked its portfolio to “fair-value.” We took Sirrom’s SEC filings and built a database that tracked the cost and fair-value of every investment in each period. By tracking the performance of loans by the year of origination, we determined that although the overall portfolio statistics appeared appealing, rapid asset growth masked poor results. We estimated that from inception to final maturity, roughly 40 percent of the loans went bad. Moreover, the data indicated management had ample advance warning of problems and was slow to recognize them in the portfolio markings.

Many mezzanine lenders receive free equity warrants known as equity “kickers” because the free warrants kick up the returns. Sirrom marked the loan and the equity kicker separately for valuation purposes. The database revealed that when trouble arose, management would mark down the equity kicker, but would leave the loan at full value. Obviously, if the equity value is reduced, then the risk in the loan has increased, making the loan less valuable as well. Management did not take that into account and kept the loans at full value until it determined that a loss on the loan was inevitable. In looking at the history of the loans, not surprisingly, writing down the equity kicker proved a reliable predictor of future loan write-downs. Further, an initial loan write-down often preceded a further write-down until eventually there was a final loss, or write-off.

This should not happen. If Sirrom’s management marked the portfolio fairly, then future adjustments should be independent of prior adjustments. No pattern should exist. In trading markets, when bad news arises, the market resets the value of securities to the point where at the new price the securities are expected to generate a positive future return. If Sirrom did this, then write-downs should not beget further write-downs. The only explanation was the management was slow to fully acknowledge bad news. And there were other red flags. For example, Sirrom’s auditors, Arthur Andersen, wrote in the 1996 audit opinion that “We’ve reviewed the procedures used by the Board of Directors in arriving at its estimate of value of such investments and have inspected underlying documentation, and in the circumstances we believe the procedures are reasonable and the documentation appropriate.” In the 1997 audit letter, Arthur Andersen removed that sentence.

People began to ask questions and raise doubts. The company managed a final equity raise led by Morgan Stanley in March 1998. In July, Sirrom announced slightly disappointing quarterly results, with two bad loans losing around $10 million, or about twenty-five cents per share. The shares fell from a high of $32 in May to around $15 in July. We covered our short at $10 a share, just before the shares collapsed to under $3 in October.

We got wonderfully lucky in demutualized Summit Holdings Southeast (SHSE), a Florida workers’ compensation specialist. The combination of conservative accounting as a mutual, all the IPO proceeds going to the company and a management team with a large initial stock and option grant, made this appear to be a fat pitch. We invested about 15 percent of the fund at $14 per share in May 1997.

Even better, SHSE had recently begun reducing risk by purchasing reinsurance on very favorable terms. Essentially, reinsurance companies were willing to take most of the risk and pay SHSE a huge fee. We believed that when the market realized SHSE evolved from a risk business to a high-quality, predictable-fee business, both the earnings and multiple would expand. We were actually disappointed when SHSE announced its sale to Liberty Mutual for $33 per share in cash in June 1998.

It turns out that management was savvy and we were fortunate. At the IPO road show, the CEO made the offhand comment that he wanted to sell the company “before the warranty ran out.” I heard the comment, but it did not fully register until later that year when Unicover was exposed. Unicover was a reinsurance broker that induced reinsurance companies to reinsure workers’ compensation on uneconomic terms. Sometimes the same risk was passed around several times. With each transfer, Unicover