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) 📕

them to value securities based on what they are worth today. An arm’s-length buyer would take into account higher risk and would demand a higher return on a loan that deteriorated. A higher return requirement translates to a lower value. It was aggressive and, in my opinion, improper to wait for an investment to be permanently impaired before writing down the value. My job during these calls was not to argue, but to hear their side of the story. I responded only, “I see.”

Sparrow continued to defend carrying loans that deteriorated at cost. “Grade 3 tends to be carried at cost because nothing has been lost yet; we don’t believe there is permanent impairment there yet,” she said. “So, it’s only when we believe that truly it’s gone and once there is a write-down we take the position that it is permanent. We’re not taking it down because we think it’s going to come back. I mean, obviously we’re going to work real hard to make it come back if we possibly can, but we don’t want to tell our shareholders, ‘Oh, it’s down today, but it’s back tomorrow.’ You know, if we write it down, we think it is gone and so it’s permanent.”

It was plain she was openly admitting improper accounting. “Right, I understand,” I said. I wondered whether Allied realized that what it was doing was wrong or whether the company was simply unsophisticated.

Then I asked her about writing down the loans when the equity kicker has been written down. Allied doesn’t need to, she said, because it believed at that point it was not losing principal or interest on the loan.

The market values debt based on Treasury bonds, which are presumed to have no risk, and then adds a spread representing the credit risk of the particular debt instrument. So, I asked whether Allied valued its loans based on spreads to Treasuries.

“No,” she said, “long term it’s tended to show fair-value over what a willing buyer and willing seller over a reasonable period of time would be willing to exchange assets. So it’s not supposed to be a fire-sale or a liquidation kind of valuation.”

This seemed like a non sequitur. I hadn’t referred to a fire-sale or liquidation values. I knew her answer was wrong, and thought she was plainly avoiding my question. “Sure, I understand,” I said.

We discussed several winning investments in the portfolio. She volunteered Business Loan Express (BLX), Hillman, and the Color Factory. We discussed Allied’s rapid growth in fee income. This came from Allied’s strategy to have more “controlled” companies, meaning Allied owns the majority of the equity. By controlling companies, Allied can charge various fees for services. Allied was principally a mezzanine lender until around 2000, when it shifted strategy to add controlled companies to the portfolio. According to Sparrow, almost everyone working at Allied helped provide services to controlled companies. Allied even billed Sparrow’s time. We reviewed the real estate portfolio and then asked to discuss the specific private finance loans. Sparrow suggested a follow-up call with Allied’s CFO, Penni Roll, to cover those.

So we reassembled on May 1 for a lengthy call with Roll. I wanted to create the same kind of static pool data we created with Sirrom. A static pool analysis looks at loans in groups based on when they were originated. This analysis is particularly helpful in analyzing growing portfolios, where new loan growth can sometimes mask the developing losses in earlier loans. We hadn’t been able to do this for Allied because it did not disclose the loan maturity dates, even though this is required by SEC Regulation S-X. (Allied began disclosing individual loan maturity dates in its 2004 annual report.) We had trouble tracking loans by year of origination because Allied’s corporate restructuring in 1997 made data older than that difficult to compile.

Lacking the data, I asked Roll about the historical credit loss rate. She indicated it was less than 1 percent of principal per year. (Later, Allied showed this figure in its SEC filings, but stopped after we questioned its accuracy.) That figure seemed absurd to me. In a low-interest-rate environment, Allied charged interest rates in the teens for mezzanine loans to middle-market companies. No one achieves a credit loss under 1 percent a year over time on these types of risky loans. An excellent average annual loss rate would be 3 percent to 4 percent. Allied’s loans had to be riskier than high-yield loans, and much riskier than bank loans, which recently experienced loss rates much higher than Allied claimed for its portfolio of mezzanine loans. Loss rates on risky corporate debt instruments spiked in the bear market. Apparently, none of this hit Allied’s books. Was it truly better investing or simply an accounting regime that delayed losses until they were deemed permanent?

I asked her whether Allied’s loans were more or less risky than an index of publicly traded high-yield bonds. Roll said, “We think what we do from a structural perspective of the instrument itself is less risky. If you look at a high-yield bond portfolio, a high-yield issuance typically has very little teeth in the financial instrument itself. And very little covenants, and payment default is always the biggest thing that can put you in default versus a lot of financial ratios.

“So Bill Walton, our chairman, kind of equates it to, if you’re going to a basketball game, if you’re the owner of a high-yield instrument, you have a ticket to watch the game. If you have a subordinated debt instrument like ours, you’re on the court playing the game. So, you don’t have a lot of rights as a high-yield bondholder. As the holder of a highly structured privately placed subordinated debt instrument like we would have, you have a lot of teeth in your document. You have tight financial covenants, you have covenants with respect to what they can and can’t do with the company, assets they can or can’t sell, people that have remained in the company