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) 📕

took $67 million in other write-downs. According to Sweeney, Allied wrote-down five companies by $20.6 million due to softening in the manufacturing sector, five other companies affected by declines in technology spending by $14.7 million, two media companies by $7.7 million due to declining values in the sector, and, finally, two others suffering “difficulties, as a result of the attacks on September 11,” by $11.3 million. Allied didn’t explain why it took over nine months to recognize September 11 impacts. It was plain that all these bad things did not happen in a single quarter, but reflected Allied’s response to scrutiny.

Allied also found a large number of offsetting write-ups. In fact, the headline earnings were 71 cents per share, which exceeded analysts’ forecasts. The commercial mortgage backed securities (CMBS) portfolio, which Allied historically valued at amortized cost, was now worth $20.7 million more because, Sweeney said, “in accordance with ASR 118, we determined the fair-value of the portfolio on an effective yield-to-maturity basis.” Tellingly, Allied still contended the mezzanine loan portfolio shouldn’t be valued on a yield-to-maturity basis, as per ASR 118.

During the earnings conference call Q&A, Don Destino, a bullish analyst from Bank of America, observed that this was the first time Allied meaningfully changed the valuation on the CMBS portfolio and asked whether it planned on doing the same exercise from now on. “Yeah, well, Don, actually, we do this every quarter,” Sweeney replied. Sure.

Even more problematic, Allied increased the value of Business Loan Express by $19.9 million and provided one of the most convoluted explanations I’ve ever heard. When Benjamin Disraeli said, “There are three kinds of lies: lies, damned lies, and statistics,” he could have used this as a case study. Penni Roll, Allied’s CFO, said that in 2002 BLX had $85 million of revenue, $43 million of earnings before interest, taxes, and management fees (EBITM), $4 million of pretax profits, $286 million of total assets, and total debt of $183 million. Roll said financial service companies are valued using net income.

The problem was, with all the fees and interest Allied charged BLX, it had minimal net income. “So to value BLX,” Roll explained, “we determined what this company’s net income would be with a capital structure that would likely be imposed upon this company by a buyer if it were sold today.” Allied already owned BLX and could impose any capital structure it liked on BLX. Why would a different owner use a better capital structure, if there were such a thing?

“As you know, we have capitalized BLX with $87 million in subordinated debt in addition to our preferred and common equity investments,” she continued. “For purposes of valuation, we assumed that our subordinated debt would be treated as equity and that BLX would be able to increase the size of its senior debt facility.”

How could this be? BLX, with Allied owning it, had a much smaller senior lending facility. That facility could only be obtained with Allied guaranteeing the first 50 percent of any loss the lender would have. Why would a different owner be able to obtain a larger senior facility on better terms?

The analysis continued. “We believe that BLX could have by the end of 2002 borrowed senior debt of approximately $155 million secured by assets on their balance sheet[, since]. . . at any point in time roughly 30 to 40 percent of their assets are in cash or government-guaranteed interests.”

How did they come up with $155 million? Thirty-five percent of $277 million in assets was about $95 million, roughly what BLX had drawn on its line. What was the rest of the collateral? (Incidentally, though Roll said BLX had $286 million in assets a few moments earlier on the conference call, Allied’s 10-Q indicated BLX had only $277 million in assets at the time.)

Roll continued, “We included an annual interest cost of $5 million and subtracted that from their approximate $43 million of EBITM to arrive at a pro forma profit before tax of about $38 million.” This implied a 3.25 percent interest rate on $155 million of debt. This is approximately the rate Allied charged just to guarantee BLX’s existing bank debt, which BLX paid in addition to what they paid the senior lender. How could the hypothetical larger bank facility also come at a reduced rate? Allied, a much better credit, paid about 7 percent on its own debt. If BLX could really borrow $155 million at 3.25 percent, it should have done that.

“We exclude management fees paid to Allied Capital in the pro forma calculation because the majority of our integration services have been completed and a new buyer for BLX would not need to incur these expenses going forward,” Roll said. How could they exclude the management fees? Weeks earlier, Allied explained it provided essential, value-added, and easily justifiable services to BLX for the fees. It was suspicious that now that Allied was under scrutiny, suddenly BLX wouldn’t need to purchase as many services from Allied.

Next, Allied explained that it took the $38 million of pro forma pretax profit, taxed it and applied a price-to-earnings (P/E) multiple. It calculated the multiple through several methods, including looking at the trading multiples of comparable companies. Allied selected CIT, Financial Federal and DVI as comparables. However, CIT and DVI traded around book value. When the market values companies based on book value rather than earnings, the earnings multiples lose relevance. Further, CIT and Financial Federal employed portfolio-lending accounting, where income is recognized over the life of the loan, instead of gain-on-sale accounting, where income is recognized up-front at origination. The market generally rewards more conservative accounting with a higher multiple. Here, Allied imputed the relatively higher multiples of the portfolio lenders to BLX’s lower-quality gain-on-sale-driven results.

Allied completed the valuation of BLX by adding back the $155 million of hypothetical senior debt and adding $15 million of future cash flow to calculate BLX’s enterprise value to be $390 million. When all was said and done, Allied applied a 17 percent