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) 📕

Investors didn’t need to read Allied’s white paper to learn about fair value. It’s not up to Allied; it’s up to the SEC. In 1969 and 1970, the agency issued accounting series releases (ASRs) describing how investment companies need to value investments. ASR 118 says, “As a general principle, the current ‘fair-value’ of an issue of securities being valued by the Board of Directors, would appear to be the amount which the owner would reasonably expect to receive for them upon their current-sale.” Then, it elaborates on how to value both marketable and unmarketable securities. ASR 113 indicates it is improper to continue to carry securities at cost if cost no longer represents fair-value as a result of the operations of the issuer, changes in general market conditions, or otherwise. Furthermore, investment companies have to take into account restrictions on selling when determining fair-value.

Shortly after the conference call, I did as Sweeney asked. I downloaded the white paper, Valuation of Illiquid Securities Held by Business Development Companies. It comes right out and challenges the SEC-issued ASRs. It argues, “The concept of ‘current sale’ in ASR 118 is particularly troubling if applied to a BDC’s illiquid portfolio, because if such a portfolio were subject to a current sale test, the portfolio would need to carry a significant discount from the face value of its underlying securities.” The white paper continues, “The concept of current sale for the purposes of determining fair value in ASR 118 is difficult, if not impossible, to apply in the case of a BDC’s portfolio.”

The paper boldly asserts, “The current SEC regulations and interpretive advice for valuing a security at fair value applicable to investment companies [is] . . . not specifically applicable to BDC’s.” Further, according to the paper, the SEC-mandated rules “are not easily applied to the unique characteristics of a BDC portfolio, primarily because the securities in which a BDC invests cannot be put to the test of current sale for purposes of valuation.”

So, according to Allied, the SEC rules don’t apply to the company. Indeed, if it had to follow the SEC rules, which require the current-sale test, the company’s portfolio would have to be carried at a significant discount. In fact, Allied conveniently said that a current-sale test is too difficult to employ because the securities are illiquid.

The white paper brazenly flaunts Allied’s use of non-SEC-sanctioned accounting. Instead, it calls for more lenient SBA accounting. Under SBA methods, assets are written down only when they are deemed to be permanently impaired. “SBA policy is far more applicable to the portfolio of a BDC than the valuation guidance set forth by the SEC in the ASR’s,” the white paper explains in alphabet-soup fashion.

The conclusion of the paper could not have been clearer. “SBA policy, with minor modifications, appears to provide the best overall guidance for valuation of fair value for the portfolio of a BDC . . . BDCs, therefore, should adopt investment policies that encompass the guidance provided by the SBA, taking into account that all private illiquid securities may have unique characteristics that impact value.” I have never before or since seen a company publicly indicate that it ignores SEC rules. Somehow, Allied did this without fear of repercussions.

After producing the white paper, Sweeney said on the conference call that Allied isn’t a normal investment company and investment company accounting should not really apply to it. She indicated the public markets don’t value BDCs at net asset value, but rather based on dividend yield. While they are subject to the Investment Company Act of 1940, they are different from mutual funds because they are “internally managed operating companies” and don’t report results like mutual funds, but, instead, file 10-Qs and 10-Ks like operating companies.

Sweeney continued to explain why Allied shouldn’t be viewed as an investment company:

“What we do think is important to our valuation as a public company is our net income, which communicates our earnings power to shareholders. The idea that we should be marking long-term, illiquid investments to some artificial or theoretical market instead of telling shareholders what we really think we have made in gains or lost in principal seems theoretical at best and at least confusing. We don’t hide what we’ve lost by claiming a temporary decline in market. When you read our income statement and look at net income, you know where we think we actually are and don’t think it serves any purpose to cloud our results with a lot of temporary unsustainable ups and downs.

She continued, “Net income is the predictor of future dividends for shareholders. [Investment losses] will decrease dividends; real investment gains will increase dividends. Mutual funds trade in the public markets at net asset value, and they mark their portfolios daily because they are simply pools of securities that have a value that is shared by the fund’s shareholders. Mutual funds are typically externally managed. Mutual funds must stay very liquid and be very precise on their net asset value calculation, because they are subject to daily redemptions should their investors take money out of the fund by selling their shares. Net asset value is the primary method by which mutual funds trade. In contrast, Allied Capital, like most BDCs, invests in long-term illiquid securities. Any increases in value are realized over a long period of time. BDCs typically do not trade their securities; they invest until maturity or until ultimate sale of the company that has issued the securities. BDC shares are not subject to redemption.”

Allied’s 2001 annual report issued in early 2002 echoed Sweeney’s conference call statement, Roll’s private description, and the white paper’s thesis. For example, Allied’s official policy stated, “The company’s valuation policy considers the fact that privately negotiated securities increase in value over a long period of time, that the Company does not intend to trade the securities, and that no ready market exists.