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) 📕

of its investments. The amount of investments written up each period correlated with the amount written down each period. (The correlation was 0.93, R-squared was 0.86, the t-statistic was 7.4, and the confidence level was 99.5 percent.) The relationship grew even stronger in the five quarters after Allied changed its accounting in June 2002. (The correlation was 0.99, the R-squared was 0.98, the t-statistic was 13.4, and the confidence level was 99.9 percent.) This meant that Allied artificially “managed” its write-ups and write-downs.

Write-ups and write-downs should be negatively correlated, or inversely related, because moves in the economy and capital markets generally occur in only one direction per period. As Allied’s portfolio investments were positively correlated with the economy, the values of write-ups and write-downs themselves should be negatively correlated. In a strong economy, there should be many write-ups and fewer write-downs. Conversely, in a weakening economy, there should be many write-downs and fewer write-ups. Our analysis showed that Allied did the opposite in order to fabricate smooth performance: Allied wrote-down its problem investments gradually over time and matched them with offsetting gains as they developed.

We did a third statistical analysis that showed a serial correlation between current and subsequent changes in the value of Allied’s investments. The data showed a 99.9 percent probability that initial write-downs of investments are disproportionately followed by further write-downs of the same investment. If management were marking the portfolio fairly, then future adjustments should be independent of prior adjustments. No pattern should exist and write-downs should not beget further write-downs. Just as we saw in Sirrom years before, the only conclusion to make was that Allied was slow—intentionally slow, profitably slow—to account for bad news.

That was more than just bad behavior. It is illegal for investment companies to smooth their performance by matching winners to losers and belatedly recognizing problems. This inflates the earnings and the balance sheet. Allied’s practice of delaying write-downs enabled them to dilute the eventual impact of the losers by repeatedly selling additional equity in the interim. Also, it gave investors a false impression that the investment results are smoother, more stable and less risky than they really are. The statistical analyses showed that this was not a case of a few isolated anecdotes of inflated valuations, but a broad, systemic pattern of reporting manipulated and misleading results. Some frauds are more obvious than others. Because this one seemed too sophisticated for regulators to catch, we tried to give the government a statistical analysis, which would make it clear, even to them.

Along with the statistical analysis showing how Allied illegally smoothed its portfolio performance, my SEC follow up letter contained a lengthy discussion of BLX, noting Allied’s high purchase price of BLC Financial (Allied paid four times book value, and an unusually large premium to the pre-deal trading price) and pointed out that even as Allied reported interest and fees from BLX, the subsidiary burned cash. The money path was circular: Allied extended additional investment to BLX each quarter. Allied began to disclose some summary financial information for BLX in the June 2002 quarter and had then made a full year of those disclosures, which showed that BLX’s loans did not have the cash economics that Allied promised at its investors’ day in August 2002. Cash premiums on loans sold averaged only 4.3 percent, rather than 10 percent. Residuals grew $56 million in the year, compared to earnings before interest, taxes, and management fees (EBITM) of $44 million, meaning 126 percent of its EBITM was non-cash. This meant that BLX generated no cash to pay Allied: All of Allied’s “revenues” from BLX were funded by Allied putting more cash into BLX.

Even as origination volume and EBITM hadn’t changed much and Sweeney insisted on the July 29, 2003, conference call that Allied valued BLX using the same valuation process, Allied increased BLX’s enterprise value to $465 million as of June 30, 2003, from $390 million the previous year.

Allied recognized “unrealized appreciation” of $50 million in its BLX investment that quarter. Since Allied reported $59 million of net income that quarter, the BLX mark-up was most of Allied’s earnings. The write-up more than offset sizeable write-downs from four other investments: $14 million from Executive Greetings, $10 million from ACE Products, $8 million from Color Factory, and $7 million from Galaxy American Communications.

Allied explained that part of the increase in BLX’s value came from an increase in the multiples of comparable companies. The multiples did expand in the June 2003 quarter from the March 2003 quarter, and on the second-quarter conference call Allied cited the higher public multiples to justify the enormous write-up of BLX’s value—even though its operating results had not improved. However, in the September 2002 quarter, comparable company multiples had fallen an average of 32 percent and conveniently that decline did not cause Allied to write-down BLX. All told, the multiples in June 2003 were lower than in June 2002. We didn’t know how Allied changed its valuation methodology for BLX, but certainly it did.

The following quarter, Allied disclosed that it changed the comparable companies it used in its analysis. Allied dropped DVI, Inc., which went bankrupt, and replaced it with additional companies that used portfolio lending accounting, including HPSC Inc., GATX Corp., and Capital Source. This was the first time that Allied identified the publicly traded comparable companies in an SEC filing. Allied said on the conference call that the comparable group was “about the same,” but it had actually changed dramatically.

Finally, the letter to the SEC discussed Allied’s other investments in Hillman, GAC, Startec, Fairchild, Powell Plant Farms, Drilltec, the CMBS portfolio, and Redox Brands. We reminded the SEC about the experience of Todd Wichmann, the Redox chief executive, who said Allied asked him to falsify his company’s financial statement to avoid problems with the senior lender. We also summarized Kroll’s findings about American Physician Services.

“Simply put,” I wrote, “in our view, Allied continues to engage in valuation and accounting fraud, and then attempts to disguise its valuation practices