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 changed description of Allied’s accounting. Gone was the analysis that it marks investments to what it believes it will eventually collect. Gone was the discussion that the current-sale test was difficult or impossible to apply to a BDC. Gone was the notion that it should ignore temporary changes in value and use SBA-styled accounting treatment, where assets are written-down only when they are deemed to be permanently impaired. In fact, Allied retracted almost every description it had used for its accounting that it had made over the past several weeks. Now, suddenly, the current-sale test, which always applied to everyone else, also applied to Allied. Not only that, but according to management, this had always been the case because its accounting was “consistent.”

Sweeney was getting closer to the correct SEC interpretation of the meaning of current-sale, but she wasn’t quite there. The required definition of current-sale refers to the price that an arm’s-length buyer would pay for the specific security Allied held and not for the entire company, if it were sold. This was confirmed by the SEC’s Doug Scheidt, who had written to the Investment Company Institute and cited an SEC case captioned In Re Parnassus Investments, where the SEC found “that a board’s valuation of a portfolio security based upon what the security would be worth upon the sale of the entire company as a going concern, when no such offers were forthcoming, was not determined in good faith.” Certainly, Allied’s management was aware of the distinction of the value of the entire company versus the value of a specific security in that company. Allied cited this case in its white paper. It is the same decision that says investment companies should not value investments at “fire-sale” prices.

While a total enterprise value calculation makes sense for valuing equity securities—you determine the value of the firm and subtract the net debt to calculate the equity value—it does not make sense for valuing debt instruments because debt instruments have limited upside. The most a debt holder can expect to receive is the principal and the interest due. Because of this, debt securities are valued based on the risk of default. For example, if there are two debt securities yielding the same interest rate, the debt security with the lower risk of default is worth more than a debt security with the higher risk of default. If the enterprise value of a firm falls, then the risk of default increases and the value of the debt instrument declines, even when the enterprise value is still greater than the amount of debt outstanding.

Allied’s argument that debt securities are worth par whenever the enterprise value exceeds the debt outstanding is fundamentally flawed and ignores the impact of increased risk of default when the enterprise value falls. It is market practice to reduce the value of debt instruments when the equity cushion shrinks. In Allied’s view, as long as there is any cushion, the debt is worth cost. Allied’s comparison of enterprise value to the last dollar of debt in this manner is simply another description of an improper “impairment” test rather than a current-sale test.

When a questioner pressed Allied on its practice of valuing nonperforming loans at cost, Walton backed off and tried to soften Allied’s previous position stating, “We say freely a Grade 4 loan is at par because we think that’s the amount we’re going to get in the value chain and that we’re getting a par return on it. Now, investors when they look at our portfolio can say, ‘Well, gee, they’ve got this amount in Grade 4 that aren’t earning any interest, I think those things are worth a little less.’ They’re free to do that. That’s part—that used to be called security analysis. And then they can say, ‘Okay, I think it should be a little less.’ But that’s not because we’re trying to hide losses. There’s nothing there we’re hiding. We’re saying this is the way we do it.”

Thus, Walton admitted the obvious: The Grade 4 loans, where Allied believed it eventually would recover the principal but not the interest, were not really worth cost even as Allied valued them at cost on its books. Nonetheless, it is Allied’s job to determine how much less they are worth and reflect that on its financial statements. Allied can’t delegate this responsibility to investors as “security analysis.” It is absurd to expect investors to understand by how much Allied overstates its loan values, particularly since Allied does not disclose the performance of the underlying companies, most of which are private.

Next, Sweeney addressed BLX. “The criticism from the shorts seems to be centered on two allegations. First, they say that Allied is taking excessive money from BLX in interest payments and fees. Second, they claim that we have chosen not to consolidate BLX’s financial statements, with the innuendo that BLX is really nothing more than a sham company reminiscent of Enron’s off-balance-sheet special-purpose entity. These allegations are totally baseless. Let’s look at the facts.”

She said BLX had met its business plan goals, was current on its bank debt, had average delinquencies on its SBA portfolio, and received the highest SBA rating for a preferred lender. She said that Allied performed substantial consulting services for BLX, including loan systems integration, marketing, human resources, Web site development, and board recruitment, which more than justified the management fees. (Eventually, we would learn that BLX’s board consisted entirely of BLX and Allied insiders, including Walton and Sweeney. How much did they charge for that board recruitment exercise?) She repeated that 25 percent wasn’t an excessive interest rate to charge BLX because Allied earned nothing more on its equity investment in BLX. This was consistent with Allied’s past comments on BLX.

She continued, “FACT: The consolidation issue is absolutely black and white. Since Allied Capital is a BDC, the rules for accounting for investment companies is quite clear. No investment companies may consolidate the financial results of its portfolio companies into its own. Nevertheless, if