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) 📕

with roughly $130 to $140 million of revenue and operating above . . . breakeven . . . so there’s value here and certainly there is value in our DIP instrument. We’ve also got a $10 million secured piece of paper in there, which we also feel, based on our views about how the company will come out of bankruptcy, will be money good.”

Startec’s bankruptcy records indicated monthly revenues had fallen to $5 million. Eventually, we learned that Walton’s quoted revenue figure included revenue from discontinued business lines. Startec, a communications company, was losing money and burning cash. Again, weeks later, on the June 30 balance sheet, Allied wrote the “money good” portion to zero.

Dan Loeb, who manages Third Point Partners and is never afraid of asking tough questions, asked the first question on the call. “On your fair market valuation, you seem to draw a distinction about where things trade versus where you mark them.”

“Let me be clear, they don’t trade,” Walton interjected.

“Okay, but let me give you an example,” Loeb said. “Velocita debt does trade. It trades at about two cents on the dollar. My understanding is that you are carrying Velocita at a price of forty. And these aren’t just distress fire-sale, you know, sales. This is a real market level.”

Sweeney argued, “Yeah, but I think you also have to look and say, ‘Is that a market?’ I mean, in the case of Velocita, if it trades at all, it’s by appointment.”

“Well, I can make an appointment to buy those bonds at two,” Loeb responded. “Yet, you’re still carrying yours at forty.”

“Yeah, but the question is, who are you buying them from because . . .”

“It doesn’t matter,” Loeb said. “I mean, there is a level. Put it this way, you’re so far off the market. Put it this way, are you buying more bonds, then, at these levels? Are you buying them at twenty, twenty-five, and thirty?”

“No, because that’s not our business to do that,” she said.

“Look at it this way,” Walton said a moment later. “We had a total investment in this that’s roughly $15 million. It’s down to $4 [million] and we feel that’s a very aggressive write-down. We’re evaluating the situation as we go forward. We’re working with—talking with management, etc., etc. If we feel like it’s going to be less than that based on our continuing to work with it, we’ll take it down the rest of the way.”

“I know you have a big portfolio with a lot of things in there. That one slipped through the crack,” Loeb quipped.

Sweeney defended the valuations by arguing that when Allied exits investments, it achieves the most recent carrying value. According to Sweeney, this proves that the investments couldn’t be mismarked and shows that “we are pretty good when it comes to fair-value accounting.”

Her reasoning suffers two basic flaws:

First, there is selection bias: Allied chooses which investments it exits. Suppose Allied has two investments carried at $10 million. If Allied tries to sell them and receives a bid of $10 million for one and $5 million for the other, Allied can decide to sell the first one and keep the second at an inflated value. Allied can hope that the overvalued investment will eventually grow into Allied’s carrying value. As Allied sells additional shares and grows its equity base, the overvaluation becomes a smaller proportion of Allied’s equity, which makes the overvalued investment less material over time. The technical term for this might be pyramid-scheme accounting.

Second, because the investments are typically not registered securities, it usually takes Allied more than a quarter to negotiate, structure, and close sales. This gives Allied time to revalue investments tantalizingly close to the actual sale price just prior to exiting them. Comparing exit prices versus the previous quarter’s carrying value after Allied had an opportunity to revalue the investment to reflect the pending sale price is a meaningless exercise. When you have perfect knowledge, it’s really easy to get the valuation exactly right. Certainly, it does not validate Allied’s general valuation practices.

Loeb wasn’t done. He asked if Allied’s business resembled a closed-end fund. Walton responded that Allied is actually an operating company, providing significant managerial assistance to its portfolio companies. The transactions are privately negotiated, and Allied has board observation rights or serves on the board in every deal. Allied provides significant assistance in financing, mergers and acquisitions (M&A), employee benefits, marketing and all sorts of areas to help grow the business. “So our business is not a passive buy-and-hold and trade business,” Walton said. “It’s an actively managed portfolio . . . deeply involved with each management team to grow the business. And it’s a very hands-on process. We have thirty-five investment officers handling 130 companies.”

The next private-equity investor I meet who says he just puts money in and sits on his hands will be the first. They all say they provide services and add more than money to their investments. Still, they realize the funds they manage are investment vehicles, and few, if any, would consider themselves to be “operating companies.”

The time-consuming nature of negotiating and structuring the entry and exit of each investment and looking for new opportunities suggests that the thirty-five investment officers didn’t have a lot of time left to make large contributions to marketing and human resources at 130 companies. In 2001, fees totaled $46 million, or $1.3 million for each of the thirty-five investment officers providing part-time assistance. At those implied rates, it was no wonder most of the fees came from controlled companies that were not deciding for themselves whether to engage Allied for auxiliary services.

“That wasn’t really my question,” Loeb said. “The observation was that—what compelling argument would you make to invest in your company?”

“Dividends,” Walton said.

Now we’re at the heart of the matter. Allied has paid a steady or rising dividend for over forty years. It has paid the dividend whether it had profits to cover it or not. Allied’s dividend is a holy covenant between itself and