Allied Capital Bonds AFC
December 29, 2008 - 12:44pm EST by
doggy835
2008 2009
Price: 8.75 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 430 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Senior debt at 35% of par, 20% yield. AFC is issued by Allied Capital, a Ponzi scheme featured in David Einhorn's book "Fooling Some of the People All of the Time". AFC is covered at today's price even if you write Allied's assets down over 80%. Allied has some bad assets, but they're not THAT bad.
 
THE NOTES
 
Issuer: Allied Capital Corporation
Class: Senior, unsecured
Coupon: 6.875%
Maturity: 4/15/2047
IPO Date: 3/28/2007
Par Value: $25/share
Outstanding: $200m (8.0 million shares)
Pay Dates: 1/15, 4/15, 7/15, 10/15
Callable: 4/15/2012 at par
Other: AFC trades flat, taxed as interest income
Prospectus:
http://www.sec.gov/Archives/edgar/data/3906/000095013307001241/w3155797e497.htm

THE COMPANY

Allied Capital (ALD) operates as a Business Development Company under the Investment Company Act of 1940. BDCs must pay out taxable earnings as dividends and (importantly for AFC owners) maintain debt/equity ratios below 1:1. ALD primarily lends to middle market companies ($50-500m) to finance buyouts, recaps, acquisitions and such. They historically lend at 10-15% cash coupon plus some PIK and/or equity kickers. Needless to say, these are not AAA credits. Losses are recognized at management discretion, and are typically kicked down the road for years until the company has grown 10x via accretive capital raises. This turns what could be a troubling writeoff into a mere rounding error.
 
ALD also made SBA loans via their Business Loan Express (BLX) subsidiary until criminal prosecutions put a crimp in that business. You can follow the entire sordid story in Einhorn's book, complete with photos of abandoned gas stations used as collateral for fraudulent loans. Anyway, the end result is ALD recently put BLX (now called Ciena) into Chapter 11 and wrote a check for 300m+ to make good on their debt guarantees.
 
As with many BDCs, ALD's Ponzi phase has (temporarily?) ended and they are now in slow liquidation mode. ALD will necessarily apply interest and principal payments toward debt for a while. This is good for debtholders in general, but note that while AFC is parri passu with other Allied debt it is at the back of the line from a maturity standpoint. This is one reason AFC is at 35 cents vs. 75 cents for the 2011/12 maturities.
 
VALUATION
 
On 9/30 Allied had 4.6b of assets and 2.2b of liabilities. Their SEC filings list the investments, you're welcome to track down these obscure companies and try to value them. The 80%+ implied writedown I noted earlier is my main source of comfort here. On the cash flow side, Allied's portfolio produced $120m of interest and fees in Q3. After egregious exec comp and other expenses they had about 85m left over to cover 36m of interest. The portfolio also throws off cash via repayments and exits, historically 100-300m per quarter but almost certainly less going forward. Still and all, we're talking about annual cash inflows which exceed 800m which slightly exceeds the implied EV through AFC at current prices.
 
OTHER ISSUES
 
Further losses put Allied at risk of violating the 1:1 debt-equity limit. Their remedies, aside from mis-marking assets, are to raise equity or reduce debt. A coercive rights offering is the only way to raise equity right now, and with common at 20% of book value even that is unlikely. A secondary offering below book value is not allowed and preferred offerings are classified as debt and thus do not help (note: some BDCs are petitioning to change treatment of preferreds). Any equity raise would of course be wonderful for AFC. Debt reductions are more of a mixed bag. Allied could get the best bang for their buck repurchasing AFC, either in the open market or via tender, but they'll probably focus on the nearer maturities. Over time this would hollow Allied out, leaving AFC backed by nothing but the bad assets they delayed writing down.
 
RISKS
 
1. Secured debt. Allied has none today but could refinance maturing unsecured debt with secured. ALD note maturities are (mm):
 
2009 - 268
2010 - 408
2011 - 472 (plus revolver, 170 of 632m drawn)
2012 - 339
 
Any secured borrowing will stretch out the timetable, giving us more years to collect 20%.
 
2. BLX prosecutions. BLX criminal activity was concentrated in the Detroit branch office. BLX HQ was shocked, shocked to hear of this activity. I'm not aware of Blodgett-esque e-mails leading back to BLX HQ. Allied itself is one layer removed from BLX HQ and is also protected by a corporate veil.
 
3. Allied could apply for a temporary waiver to the 1:1 debt-equity limit. More problematic they could convert to a C Corp and escape the limit. I don't see how they could fund a C Corp, so it would essentially be a slo-mo liquidation.
 
SUMMARY
 
At 36 cents on the dollar and 19% yield AFC offers excellent risk/reward ratio. What makes it better than bonds yielding 20% (or even more) is a combination of AFC's low leverage, as mandated by law, and its position at the front of the capital structure.

Catalyst

1. Easing of credit crunch


2. Allied could buy back some AFC


3. Eventual equity raise
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    Description

    Senior debt at 35% of par, 20% yield. AFC is issued by Allied Capital, a Ponzi scheme featured in David Einhorn's book "Fooling Some of the People All of the Time". AFC is covered at today's price even if you write Allied's assets down over 80%. Allied has some bad assets, but they're not THAT bad.
     
    THE NOTES
     
    Issuer: Allied Capital Corporation
    Class: Senior, unsecured
    Coupon: 6.875%
    Maturity: 4/15/2047
    IPO Date: 3/28/2007
    Par Value: $25/share
    Outstanding: $200m (8.0 million shares)
    Pay Dates: 1/15, 4/15, 7/15, 10/15
    Callable: 4/15/2012 at par
    Other: AFC trades flat, taxed as interest income
    Prospectus:
    http://www.sec.gov/Archives/edgar/data/3906/000095013307001241/w3155797e497.htm

    THE COMPANY

    Allied Capital (ALD) operates as a Business Development Company under the Investment Company Act of 1940. BDCs must pay out taxable earnings as dividends and (importantly for AFC owners) maintain debt/equity ratios below 1:1. ALD primarily lends to middle market companies ($50-500m) to finance buyouts, recaps, acquisitions and such. They historically lend at 10-15% cash coupon plus some PIK and/or equity kickers. Needless to say, these are not AAA credits. Losses are recognized at management discretion, and are typically kicked down the road for years until the company has grown 10x via accretive capital raises. This turns what could be a troubling writeoff into a mere rounding error.
     
    ALD also made SBA loans via their Business Loan Express (BLX) subsidiary until criminal prosecutions put a crimp in that business. You can follow the entire sordid story in Einhorn's book, complete with photos of abandoned gas stations used as collateral for fraudulent loans. Anyway, the end result is ALD recently put BLX (now called Ciena) into Chapter 11 and wrote a check for 300m+ to make good on their debt guarantees.
     
    As with many BDCs, ALD's Ponzi phase has (temporarily?) ended and they are now in slow liquidation mode. ALD will necessarily apply interest and principal payments toward debt for a while. This is good for debtholders in general, but note that while AFC is parri passu with other Allied debt it is at the back of the line from a maturity standpoint. This is one reason AFC is at 35 cents vs. 75 cents for the 2011/12 maturities.
     
    VALUATION
     
    On 9/30 Allied had 4.6b of assets and 2.2b of liabilities. Their SEC filings list the investments, you're welcome to track down these obscure companies and try to value them. The 80%+ implied writedown I noted earlier is my main source of comfort here. On the cash flow side, Allied's portfolio produced $120m of interest and fees in Q3. After egregious exec comp and other expenses they had about 85m left over to cover 36m of interest. The portfolio also throws off cash via repayments and exits, historically 100-300m per quarter but almost certainly less going forward. Still and all, we're talking about annual cash inflows which exceed 800m which slightly exceeds the implied EV through AFC at current prices.
     
    OTHER ISSUES
     
    Further losses put Allied at risk of violating the 1:1 debt-equity limit. Their remedies, aside from mis-marking assets, are to raise equity or reduce debt. A coercive rights offering is the only way to raise equity right now, and with common at 20% of book value even that is unlikely. A secondary offering below book value is not allowed and preferred offerings are classified as debt and thus do not help (note: some BDCs are petitioning to change treatment of preferreds). Any equity raise would of course be wonderful for AFC. Debt reductions are more of a mixed bag. Allied could get the best bang for their buck repurchasing AFC, either in the open market or via tender, but they'll probably focus on the nearer maturities. Over time this would hollow Allied out, leaving AFC backed by nothing but the bad assets they delayed writing down.
     
    RISKS
     
    1. Secured debt. Allied has none today but could refinance maturing unsecured debt with secured. ALD note maturities are (mm):
     
    2009 - 268
    2010 - 408
    2011 - 472 (plus revolver, 170 of 632m drawn)
    2012 - 339
     
    Any secured borrowing will stretch out the timetable, giving us more years to collect 20%.
     
    2. BLX prosecutions. BLX criminal activity was concentrated in the Detroit branch office. BLX HQ was shocked, shocked to hear of this activity. I'm not aware of Blodgett-esque e-mails leading back to BLX HQ. Allied itself is one layer removed from BLX HQ and is also protected by a corporate veil.
     
    3. Allied could apply for a temporary waiver to the 1:1 debt-equity limit. More problematic they could convert to a C Corp and escape the limit. I don't see how they could fund a C Corp, so it would essentially be a slo-mo liquidation.
     
    SUMMARY
     
    At 36 cents on the dollar and 19% yield AFC offers excellent risk/reward ratio. What makes it better than bonds yielding 20% (or even more) is a combination of AFC's low leverage, as mandated by law, and its position at the front of the capital structure.

    Catalyst

    1. Easing of credit crunch


    2. Allied could buy back some AFC


    3. Eventual equity raise

    Messages


    SubjectDividends
    Entry12/29/2008 02:51 PM
    Memberjohn771
    Hi Doggy,

    It looks like they could free up most or all of the cash they need by eliminating the dividend. That would leave the bonds in good shape and also minimize dilution for current shareholders (that's assuming that raising equity at the current price would be dilutive). How far do you think they can cut? Could they pay the required BDC distribution in common shares? Or some kind of long-term debt or preferred (might not help their coverage ratio, but it would ease their short-term cash requirements)?

    SubjectComplete Fraud?
    Entry12/29/2008 02:59 PM
    Memberlindsay790
    I'm really only familiar with this situation from reading the headlines...leaving aside BLX, are the other portfolio companies real businesses that should support the stated NAV or something close? Just trying to figure out if this is worth rolling up the sleeves for....

    SubjectRE: Dividends
    Entry12/29/2008 04:34 PM
    Memberdoggy835
    Hi John, good point about dividends. Many BDCs have deeply cut or eliminated dividends and ALD already said 2009 dividend will be cut to approximate net investment income. That'd be $1 or so (vs. 2.60 in 2008) but I think they'll cut further. It does them no good at this point.

    Most of their 2008 dividends went to cover excess 2007 taxable income, so in theory they're still on the hook to pay out a lot of 2008 taxable income. I think they can minimize this by realizing losses and so forth. As a last resort I do think they can pay in preferred. I didn't think they could pay in common, but I recently heard of a court decision allowing REITs more freedom in this area which may also apply to BDCs.

    Lindsay, I don't think there's significant fraud in the main portfolio. Einhorn did extensive research and found mismarking in the main portfolio but the fraud was in BLX. As a SBA lender BLX operated on an originate-and-securitize type model, similar to the one which recently produced such wonderful results with subprime mortgages. Since BLX did not keep loans in portfolio and reported earnings and calculated exec bonuses using gain-on-sale the incentives were all in place for bad behavior.

    Except for some small exceptions ALD's main business is originate-and-hold. As such ALD has no incentive to make bad loans. Although you can't get financials on most companies in ALD's portfolio they are real companies operating real businesses. The issue with ALD is they don't mark loans down when borrowers get in trouble. But even if you whack ALD's carrying value by 50% AFC is still worth par. That's a pretty good margin of safety.

    SubjectLitigation and Legal Liability
    Entry12/29/2008 11:16 PM
    Memberneo628
    Have you looked into the possibility of legal liability to the SBA. I read David's Book and I got the sense that the SBA was not interested in uncovering or punishing fraud at Allied Capital for some reason. However, if this changes, that could really eat into the cushion perhaps. Also, there are a number of BDC's, some of them a lot better and wondering what your thoughts are about relative value as I am sure at least some of them have issued debt that might also be priced very attractively. Hercules Tech and the old Silicon Valley Bank are two that come immediately to mind.

    SubjectNewbie question
    Entry12/30/2008 09:28 AM
    Memberjmxl961
    I am new to this situation so a newbie question - has management changed from that described in David's book. Ditto on the board? Secondly is there any issue of fines or other legal fees re class actions etc? or is there adequate balance sheet provisioning for all of that?

    SubjectRE: Litigation and Legal Liabi
    Entry12/30/2008 11:10 AM
    Memberdoggy835
    1. Have you looked into the possibility of legal liability to the SBA?

    A little. I consider it unlikely. I think the government would first have to expand the BLX fraud investigation beyond Detroit, greatly embarrassing the SBA and its Democratic supporters. Then they'd have to pierce the corporate veil, proving ALD participated. Why would ALD entangle themselves -- it's not like BLX needed help making bad loans. Also, the whole structure was set up to avoid entanglement. Einhorn says loan approval was handled by BLX employees (basically CEO Tannenhauser himself). It seems ALD execs only became involved during workout, after a loan went bad, and even then only at the committee level. At each stage ALD kept themselves one or two steps removed from the process. Meanwhile, the SBA is charged with direct oversight, so how can you prosecute ALD without prosecuting SBA personnel?

    2. Also, there are a number of BDC`s, some of them a lot better .....

    I haven't found anything this senior trading this cheap. ACAS, another $2 stock, has a 2012 bond that traded at 90+ earlier this month. I couldn't find much for Hercules or SVB, but I'm certainly open to suggestions.

    SubjectRE: Newbie question
    Entry12/30/2008 11:48 AM
    Memberdoggy835
    ALD management and board remain in place. They are very entrenched and shareholders are too scattered to displace them. I think debtholders would end the executive gravy train in a hurry, giving management strong incentive to avoid BK.

    BLX (now called Ciena) is in BK/runoff with a different CEO. ALD wrote off their equity investment in BLX and wrote a $300m+ check to BLX's lenders. ALD carries the loan to Ciena at 180m; ultimate recovery may be far less but it's not that material. Also see my reply to Neo on BLX.

    ALD settled the Einhorn-inspired SEC action on mismarking last year. Something could come out of stealing Einhorn's phone records, but they had an agent do it so again they were one step removed (and shocked, shocked to discover it). They have a couple shareholder lawsuits as is typical after a large price drop.

    ALD is a genuine mess, but I think the assets are worth more than 20 cents on the dollar. If they BK in the next few years AFC should recover as much as the near bonds, which are priced around 75.

    SubjectLiquidation
    Entry12/30/2008 02:53 PM
    Memberabrams705
    Very interesting idea, doggy.

    Are there any BDCs that have filed for bankruptcy or liquidated in the past? And if so, could you compare how the bondholders fared in terms of timetable, recovery, etc, to a likely scenario for AFC?

    Thanks,

    abrams

    SubjectRE: Liquidation
    Entry12/30/2008 05:32 PM
    Memberdoggy835
    A friend told me of a tiny BDC which liquidated years ago. It did not go well for shareholders but I think they paid their debt. You can't really apply this to Allied.

    In the first 9 months of 2008 Allied received 400m in interest and fees and almost 900m in principal repayments. Against this they paid roughly 100m in opex and 100m in interest. These numbers imply they could retire all their debt AT PAR in 18 months if they went into pure runoff. Of course they won't go into pure runoff and principal repayments will slow dramatically, even so these numbers give me comfort for the near term. Longer term I worry about hollowing out and secured debt, but long term downside is mitigated when you pocket 20% each year.

    SubjectRecovery
    Entry12/30/2008 06:57 PM
    Memberbowd57
    Hi, Doggy -- I looked at this and wound up passing (which isn't to say it's a bad idea) because it looked recovery given default would be poor. It seemed like EOD was defined, not just for this issue but in general, as missing interest, principal or violating BDC coverage ratios. This AFC runs for -- I forget, but there's no principal due for a long time. Coverage ratios can be maintained by dumping assets, which is not necessarily good for the debt. That leaves us with interest. If the assets don't throw off enough cash to meet interest at 1:1 D/E, then they're not woth much at all. So if ALD does go BK, returns are average, and if they don't, the common will outperform, and I don't want to own the common. If that makes any sense. Yours, Bowd

    SubjectBanks get secured
    Entry12/31/2008 10:10 AM
    Memberdoggy835
    Press release:

    "The amendments add new covenants that require Allied Capital to grant to the private noteholders and the revolving credit facility lenders a first priority lien on substantially all of its assets no later than January 30, 2009 (subject to extension), ..."

    I don't know which notes these are offhand. They also get 100 bpp rate bump. While I'm not happy to see debt get promoted in front of me (especially two days after my writeup!), it's not a huge surprise. The amendment also prohibits Allied from repurchasing bonds like AFC. So much for my catalyst #2. The silver lining is some additional covenants limiting the dividend, buybacks, etc.

    SubjectRE: Banks get secured
    Entry01/30/2009 01:47 PM
    Memberdoggy835

    Allied announced this week they blew their 200% asset coverage covenant and have re-opened negotiations with the revolver and private note lenders. It is strange that the original negotiation 4 weeks ago did not anticipate this high-probability event. My best theory is Allied hoped to convince auditors to buy their optiimistic marks (again) and thus avoid blowing the covenant. In any event, as things stand today the revolver and private note lenders do not have the liens.

    I do not believe these lenders will force BK or fire sales. Scheduled interest and principal repayments are close to one billion dollars this year, almost as much as the soon-to-be-secured debt. It makes much more sense to force Allied to direct this cash flow toward debt repayment than to turn a performing asset into a non-performing one by forcing BK. The main risk continues to be the portfolio itself. If it's completely rotten to the core, instead of just around the edged, AFC could be impaired.


    SubjectRE: Author Exit Recommendation
    Entry09/03/2010 09:18 AM
    Memberdoggy835
    I'm just housekeeping, AFC at 21.50 is not a bad hold in a ZIRP environment and we still have our position.
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