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) 📕

Act of 1958. Williams had worked for the FBI for much of the 1950s, and since the Small Business Administration (SBA) and all that new funding that was available from the SBA was also right there in Washington, Williams had the good sense to headquarter Allied in the city. The company went public in January 1960, selling 100,000 shares at $11 each. The company began making quarterly distributions to shareholders in 1963. Over the years, several affiliated companies were spun-out or created with similar mandates to make debt and equity investments in small, mostly private businesses that would provide recurring cash flows. Several of these companies would go public, but some remained private partnerships. Williams served as president, chairman, and CEO of Allied and its affiliated companies from 1964 until 1992, when he was named chairman emeritus.

Allied Capital Corporation I, Allied Capital Corporation II, and Allied Capital Lending were closed-end management companies that elected to be regulated as BDCs under the Investment Company Act of 1940. They made private-equity and mezzanine investments in small businesses. Allied Capital Lending made loans through the SBA’s 7(a) loan program. Allied Capital Commercial Corporation was a real estate investment trust (REIT) devoted to investing in small business mortgages sold by the Resolution Trust Corporation and the Federal Deposit Insurance Corporation. Allied Capital Advisers managed the assets of the four other Allied Capital companies. On December 31, 1997, these five publicly traded affiliated companies merged to form Allied Capital Corporation in a tax-free stock-for-stock exchange.

At the time of the 1997 merger, Bill Walton (no relation to the former basketball star) was chairman and CEO of all the merging companies. He assumed the roles from David Gladstone, who resigned as chairman and CEO of the Allied Capital companies in February 1997. Gladstone was a long-time Allied Capital executive, having served as an executive officer of the affiliated Allied Capital companies since 1974. (Gladstone would go on to co-found American Capital Strategies before starting his own publicly traded BDC, Gladstone Capital.) Prior to assuming these positions at the Allied Capital companies, Walton had been a director of Allied Capital Advisers and president of Allied Capital Corporation II.

The rationale for the merger of the separate Allied companies was to simplify Allied’s internal operations and create critical mass to raise the company’s profile with Wall Street and make it attractive to institutional investors. As of December 31, 1997, Allied reported $800 million in total assets, including a $200 million private finance portfolio with investments in eighty-nine portfolio companies.

I asked one of our analysts, James Lin, to replicate our Sirrom work on Allied. He built a large database of all of Allied’s loans showing the cost and value of every investment each quarter for several years. The database showed that Allied’s valuation patterns repeated Sirrom’s. Allied marked down the equity kickers of problem investments, while holding the related loan at cost. This was a good predictor of a future write-down of the loan. Small write-downs disproportionately preceded further write-downs. As in the Sirrom analysis, this indicated that Allied was slow to write-down troubled assets.

The pattern of loan and equity-kicker marks revealed the problem loans. Allied invested in a few public companies, where we analyzed the SEC filings and checked trading prices to see evidence of aggressive carrying values. To protect its existing investment and delay the day of reckoning, Allied often put more money into apparently troubled situations and/or restructurings without taking proportional markdowns.

According to its own customized scheme, Allied grades its investments on a five-point scale to track the progress of its portfolio:

Grade 1 is used for those investments from which a capital gain is expected.

Grade 2 is used for investments performing in accordance with plan.

Grade 3 is used for investments that require closer monitoring; however, no loss of investment return or principal is expected.

Grade 4 is used for investments that are in workout and for which some loss of current investment return is expected, but no loss of principal is expected.

Grade 5 is used for investments that are in workout and for which some loss of principal is expected.

From James’s database and Allied’s SEC filings, we assembled a list of questions to ask the company. We arranged a call with Suzanne Sparrow and Allison Beane of Allied’s Investor Relations department on April 25, 2002. This would be my first contact with Allied, and in many ways would reflect Allied’s general investor relations practice: Officials answer the easy questions and avoid the hard ones. During this call, and in a follow-up call the next week with Penni Roll, Allied’s CFO, we raised all of our issues and concerns and listened to the company’s responses. The first call, which we recorded in accordance with our standard practice, lasted about two hours.

Early in the conversation, I asked the key question of how Allied determines the value of its investments. “How do you . . . decide what to value the equity for? What do you need, like another financing round to come in that validates the value of the equity or do you do an appraisal? How do you do it?” I asked.

Sparrow described what she called Allied’s Mosaic Theory of valuation, “It is not quantitative definitively. Certainly, there are quantitative factors, but there are also qualitative factors,” she said. “And that’s where some of the BDCs, I think, diverge on methodology with respect to valuation. You see some others who treat it truly as a quantitative exercise.”

“That’s the beautiful thing about a BDC as a vehicle,” she said a moment later. “You don’t have, you know, the bank regulators leaning on you to say you must write-off this asset.”

I asked whether Allied began writing loans down when the risk increased so it would require a higher yield or whether it waited until it realized the investment was a certain loser. She responded that write-downs started “when we believed that we had permanent impairment of the asset.”

This was wrong. As a BDC, Allied has to use “fair-value” accounting, which requires