Description

In a speech last Wednesday at a charity gathering of money managers, David Einhorn of Greenlight Capital outlined a thesis for shorting Allied Capital stock (ALD). By contrast, my suggestion is to take advantage of any short selling price weakness (and there has been plenty in the last week) and go long instead. An excellent total return in the year ahead can be reaped (9-11% yield and a 10-30% gain to pre-shorting prices), or just the near term bounce for traders is possible as Allied’s loyal shareholder base rallies to the cause, and management makes its case.

I’ve had the good fortune to speak directly to both David Einhorn and Joan Sweeney who is the COO of ALD. Both are passionate in defense of their respective point of view. I’ll lay out Mr. Einhorn’s short case first, and then what I’ve found to counter it via my own DD and the conversation with Ms. Sweeney.

This portion of my discussion can be considered the summary. Necessary details will follow in replies.

The Short Sale Thesis:

1) ALD seems to have far fewer 'defaults' than a high yield bond index.

2) Either ALD is truly a better investor OR ALD is concealing its losses.

3) Mr. Einhorn believes he has uncovered evidence of losses being concealed, citing about half a dozen examples of impaired securities being carried above market values. Some of these are Velocita, NETtel, and Loewen Group.

4) Mr. Einhorn believes ALD's point in its May 16 CC, and that expressed by sell side analysts, that the problems stemmed from telecom and they are largely behind, misses his point: Are the 'improper' valuations of these companies that can be compared to their public security prices SYMPTOMATIC of a more general problem of improper valuations in the non public portfolio securities?

5) Mr. Einhorn believes if the credit quality of an investment has declined, then that should be immediately and fully reflected in the 'fair value' stated by ALD, and reflected in unrealized losses. Mr. Einhorn believes ALD's contention that the company is holding for the term of the investment and thus should value investments on the liklihood of collecting full value at the end of the term is inadequate. "If you mark it down now, you can always mark it back up again" He believes when ALD writes down an investment it is only written down to a 'maximum recovery value'. He believes, particularly when that recovery value lies in the future, that the present 'fair value' should be shown at a deep discount to a very conservative recovery value.

6) Mr. Einhorn has a serious concern with the high fees and interest from controlled investments. I did not effectively clarify this issue with him, so I won't claim I fully understand his concern. The business model of the public RIC-BDC calls for cash to flow from investments to the parent to be paid out as dividends. Mr. Einhorn suggests the money would perform better if left at the portfolio company level.

7) In the end this is an 'integrity issue' in this post Enron world. Mr. Einhorn thinks if regulators looked more closely at the valuations, it could conceivably call into question substantial amounts of the stated NAV. That question could lead to questions by ALD's lenders as well as destroy the premium stock price employed for secondary stock sales (which he contends is the primary driver for increased NAV). Obviously this is the 'nightmare scenario'.

Collectively these concerns make for a decent risk-return ratio to take on a short position in Mr. Einhorn’s opinion.

I respectfully disagree.

The Long Case:

1 and 2) Comparison to a high yield bond index: ALD is not the functional equivalent of a basket or index of high yield bonds. What the short case misses is the ‘brains’ inside the Allied enterprise managing and maintaining ongoing involvement with the portfolio. High yield bonds are generally ‘poorly constructed’, with few if any restrictive covenants attached. Sub debt by contrast is highly structured with any of a number of restrictions built in as specifically appropriate in each transaction. Among these are 1) no asset buys or sales unless ALD approves; 2) maintenance of certain ratios; 3) cash flow coverage requirements; 4) no management changes without approval; 5) restrictions on use of proceeds. ALD generally gets board oversight. That means they can monitor and deter actions that will lead a portfolio company off track. ALD believes that is preferrable to an actual board seat, a technique used by other sub debt lenders. They are privy to board behavior, but in the case of a problem are viewed as a true lender.

Private mezzanine funds as a group perform better than junk bonds because of the above factors. Either Moody’s or Fitch wrote some time in the last year or so that a ‘structured leveraged loan is always preferable [to junk] due to control and ‘interest’ [built in].

If better performance should be expected due to the form of assets in ALD, then the basic contention that better perfomance means ‘hidden’ losses is faulty!

3, 4 and 5) Failure to properly value some public securities suggests a larger problem with the stated values of private securities held: In discussion with Ms. Sweeney, there are very good reasons for the fair valuations of specific companies to differ from the strict mark to market regime Mr. Einhorn would suggest. We discussed several specific examples cited by Mr. Einhorn. (Details in a downstream reply.) All three were explainable, are documented, and Ms. Sweeney emphatically stands by them. One critical issue is the fact that Mr. Einhorn is using hindsight, while ALD is conducting valuations in real time with a lag in some of the data available when decisions must be made. A second important factor to consider is that ALD is not an open fund. The capital is permanent, as no daily cash redemtions are needed. So after problems are apparent, if ALD conducts an analysis that an impaired security has a liquidation value of 28 cents, their opinion is they will do everything possible to get at least 28 cents for the shareholders. If the market bids 5 cents for that security today, they aren’t going to sell it at that firesale price, nor do they have to. The market arguably is not the best measure of ‘fair value’ in this setting. ALD may in fact have more information available than the market!

Ms. Sweeney and I also talked about some of the public companies that seem to have positive things happening that may not be fully reflected in positive writeups. In her view the key question in all ‘fair value’ calculation is what will ALD shareholders get? If an equity trades in the market, ALD may acutally discount the market price slightly. ALD might not get that price as an actual sale could depress the market a bit.

There are also two different kinds of buyers of companies: financial buyers and strategic buyers. FBs like ALD pay less....they are targeting return on investment. ALD values its portfolio from the view of an FB. Strategic buyers are willing to pay more for a company to operate it. Wyoming tech was bought by ALD and carried by ALD at FB ‘prices’. Wyoming Tech was sold to a strategic buyer, and the price differential shows. (The Wyoming Tech sale is pending for $85MM. ALD’s 91% interest was shown at $70.4MM.) In the last 4 years, realized gains have been consistently much higher than the underlying writeups, pointing to the validity of this idea.

With regard to valuation policy, I received notes of a conversation with John Erickson, CFO of American Capital Strategies (ACAS), another well known public RIC-BDC. ALD’s competitior's opinion is that ALD's method of 'fair valuation' "[is] not a more aggressive or conservative approach, just a slightly different approach...more of a private equity / venture capital approach, but they have been very upfront about it, as it's spelled out very clearly in their 10K's."

There is also a question about language change in the Auditor’s Letter. Apparently this is a change in language from the AICPA, the professional accounting organization. There is more on this in a ‘reply’

6) High interest and fees from controlled companies: Investing in a BDC requires that one know how (or on what basis) private companies are bought or sold. Multiples of cash flow before interest are the yardstick for pricing. The capital structure is almost irrelevant. Private companies by nature don’t have a ‘good’ capital structure like public companies. In a transaction, or valuation process, one is not ‘buying the balance sheet’. One is ‘buying’ the cash flow the enterprise can generate. As long as the cash flowing from the portfolio company is not excessive with respect to the company’s operating needs, whether it is retained or paid out isn’t that important. So there is nothing wrong with BLX, for example, paying 25% interest as a controlled investment to its parent ALD. That coupon is for clearly defined sub debt, and at 25% is at the top end of normal market sub debt returns.

7) The regulatory meltdown scenario: Ms. Sweeney regarding a regulatory audit: “Bring it on!” There have been two routine SEC audits since she has been at ALD. There has been no material change in ALD’s fair valuation policy in the 9 years she has been at ALD. There is another party that examines the portfolio valuations: the 15 short term, and 23 long term lenders providing ALD on an UNSECURED basis a combined $1.2B! In particular, the long term lenders have a very real execution risk. They all do extensive DD. The long term lenders in particular in effect are saying they trust ALD management, not only now but going forward 5-7 years! ALD is very pleased with its BBB unsecured investment grade debt rating (flat priced). How many junk bond funds have that kind of acceptance by debt markets?

Please read the following ‘replies’ that enlarge on these points. They are material to the case!

Catalyst

There have been at least two other concerted efforts to effect a short sale stategy against ALD in recent years. Both fizzled. In February, I participated in a discussion with an investor who considered a short sale strategy against ACAS. That discussion took place on the Yahoo board, and can be reviewed. He was impressed by the knowledge and loyalty of those investors. He was persuaded there would be more risk to his position than he thought. The sleepy ALD Yahoo board has similiarly erupted in the last week. It would be a mistake to discount the understanding of these issues by a significant segment of retail ALD investors, or their desire to defend their company. I expect the same fizzle to happen again. ALD as a business continues to perform as expected with the dividend (based on earnings growth) up 7.8% for the year to date. Historically large short positions have been allegedly established and that suggests a short squeeze is possible. Buy on any downward volatility before the market doubts are fully countered.