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) 📕

in earnings in 2003 and 2004. Net investment income (excluding gains and losses) was $1.65 per share in 2003 and $1.52 per share in 2004. Supported by Allied’s strategy of selling winners and keeping losers, taxable earnings were $2.40 per share in 2004 and the related tax distributions were $2.30 per share. Net income, which included unrealized losses, was only $1.88 per share. In the fourth quarter of 2004, Allied modestly reduced the carrying value of BLX by $26.1 million, nowhere near to what it should have valued it, since originations fell 30 percent from the prior year.

In the first quarter of 2005, Allied converted $45 million of its loan to BLX into equity to “strengthen the capital base” and “clean up the capital structure.” As mentioned, Allied stopped providing detailed financial information on BLX at that point, so it became harder to track. Nonetheless, converting debt to equity is not usually a good sign, because it indicates the company isn’t creditworthy enough to support the debt.

The regulatory investigations also started to create large legal expenses in 2005. In the first half of the year, Allied spent $25 million. Assuming legal fees of $300 an hour, you can employ fifty lawyers for sixty hours a week to run up a legal bill that high. In the third quarter the expense fell to half as much and to “only” $3.6 million in the fourth.

Allied had two home runs in 2005. First, it sold its entire portfolio of commercial mortgage-backed securities (CMBS) and its platform for originating CMBS to a Canadian bank for a large gain. Second, Allied made an initial small investment in 2001 in Advantage Sales & Marketing, which became a large investment when Allied rolled a number of regional competitors together in 2004. It announced a sale of the rollup for a very large gain in 2005. The combined result led to earnings per share of $6.36.

After raising the quarterly tax distribution a penny to $0.57 per share two quarters after my speech, Allied held it flat at that level for nine consecutive quarters. Given the investment performance and ever disappointing recurring net operating income, it was enough of a charade to maintain the quarterly $0.57 distribution. Now, aided by the two large realized gains, Allied began, again, to slowly raise the distribution, generally by a penny per quarter.

However, Allied found much greater competition to make new loans and reduced the interest rates it charged for the loans. The yield on its portfolio fell. Further, the $36.4 million of investigation-related costs were a headwind. Net investment income fell, again, to only $1.00 per share in 2005.

Even so, the realized gains created so much taxable income that Allied was left with a dilemma. If they paid out all the taxable income, even as a special distribution, it would be hard to have visibility on future distributions. Obviously, recurring net investment income was now much less than the distributions. Further, Allied had harvested its best gains and it wouldn’t make sense to stake the future stability of the distributions on the relatively barren portfolio. If you pick your flowers and water the weeds, you wind up with a garden of weeds.

To solve this, Allied used a rule in the tax code that permitted them to defer distributing the taxable income to shareholders for a year by paying a 4 percent excise tax. Of course, this made no economic sense. Had they paid the distributions, the shareholders would pay long-term capital gains tax at a 15 percent rate on the income. Effectively, the 4 percent excise tax was a 26 percent interest rate one-year loan. (Shareholders were deferring paying a 15 percent tax for one year. The cost was 4 percent—paid by the company: 4/15 = 26.6 percent). For that cost, Allied was able to avoid paying out a special distribution. Instead, its shareholders had to wait a year to receive their money as part of the normal quarterly distributions. In fact, when Allied told the shareholders that it created this rainy-day reserve fund to give added visibility for future tax distributions, the shareholders, focusing on regular quarterly “dividends,” cheered.

A side benefit of the spillover distribution was the complete transition of the business from being operating-earnings driven to capital-gains driven, and finally to paying the distribution out of an earlier year’s capital gains. With operating earnings no longer relevant, Allied lost most of its incentive to control its operating costs. Consider Table 26.1, comparing results in 2001, the last year before my speech, and 2005.

Table 26.1 Allied Operating Results

Operating earnings have fallen in absolute dollars, as a percent of assets and on a per-share basis. This is true, even if you back out the investigation costs. Meanwhile, employee and administrative expenses, excluding the investigation costs, have grown much faster than assets. But growing fastest of all: senior management compensation.

CHAPTER 27

Insiders Getting the Money Out

Allied might have felt that it was being protected by its friends in Washington, but that’s a big assumption to make when millions of dollars are at stake. There was no way to be sure that all the influence would derail regulators and their investigations. And if regulators did take action, some senior executives at Allied who were rich “on paper” would become much less so.

In April 2006, as part of Allied’s announcement of its upcoming annual meeting, it told shareholders in its proxy that they would be voting on details of a misleadingly named employee “stock ownership initiative” during the meeting. That might have sounded innocent to shareholders, because companies are always amending these plans and shareholders are always approving them. It sounded almost boilerplate. But this one was different and not so innocent.

Allied’s officers and senior employees hold millions of dollars’ worth of stock options, given to them as part of their compensation. Allied’s officers had to know that there was a real possibility that the various government investigations could lead to serious consequences, causing the stock to plummet and the value