Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (12 page)

Now, let’s look at the valuation methodology we use. It is simply beyond dispute that it is both appropriate and consistently applied. Allied Capital developed a white paper, which is posted on our website to describe this valuation methodology. To summarize: Allied Capital’s Board of Directors makes a judgment in good faith to appropriately value the portfolio on a quarterly basis using a valuation policy that has
been consistently applied based on the estimated price that a portfolio company could be sold for if a willing buyer and willing seller were to negotiate at arm’s-length.
That judgment includes factors recommended by the SEC in accounting series releases that go back thirty years. It includes such factors as the company’s current and projected financial condition, cash flow and profitability, net liquidation value of tangible business assets, yield to maturity with respect to debt issues, debt to equity ratios and so forth.

While this comment is interesting, it is not accurate. In fact, the Allied white paper stated the
opposite
. As discussed in Chapter 8, the whole point of the paper was to rationalize
not using
the SEC accounting series releases. Clearly, Allied had received some advice (the advice probably came from the SEC, though it is possible Allied hadn’t yet heard from the SEC and simply realized its own mistake) that its white paper, with its brazen view that SEC valuation guidance did not apply to them, was wrong. Allied now ran away from its white paper as fast as it could. Allied changed its tune and would no longer claim that SEC policies don’t apply or that measuring the value between a willing buyer and seller at arm’s length was difficult or impossible to apply to its investments.

Sweeney continued her script with what she called “FACTS” or, better yet, “INDISPUTABLE FACTS.” This type of wordplay was typical of Allied’s approach. Apparently, Sweeney felt that if she said the word FACT loudly enough, with enough emphasis, many people would accept what she said as true.

She then tried to defend Allied’s accounting policies. “Regarding the question of propriety of our methodology,” she said, “here are a few indisputable facts. FACT: The valuation methodology outlined in our white paper is nearer in our form and to [the] shelf registration statement, which is filed every quarter with the SEC, and the SEC has consistently found these filings satisfactory.” Of course, Allied had only introduced this language in its SEC filings earlier that year, giving the SEC little time to opine on it.

Further, Sweeney said that Allied’s statement of accounting policies matched the white paper and was Allied’s actual practice. Allied’s current annual report echoed the white paper, stating, “The Company will record unrealized depreciation on investments when it believes that an asset has been impaired and full collection for the loan or realization of an equity security is doubtful.”

However, starting with this conference call, Allied switched its descriptive language from an impairment test to current-sale valuation based on where willing buyers and sellers would transact. Without fanfare, in its next SEC filing, Allied eliminated the offending language that had described its valuation methodology in terminology consistent with its discredited and withdrawn white paper. Eventually, Allied would say the white paper was a “discussion piece for an industry conference” and claim that it never actually used that type of accounting.

Sweeney continued, “FACT: Mark-to-market and fair-value are not the same thing. It has been falsely stated that the appropriate valuation method to be used is a rigid mark to market or fire-sale.” Presumably, she meant it was falsely stated by short-sellers, though I don’t know who.

Of course, this was more wordplay. We argued that fair-value accounting required a mark-to-market approach. She simply added the part about fire-sale. This was a convenient invention because the SEC said fair-value accounting should not require a fire-sale valuation. Having now falsely tarred us as claiming that Allied needed to use fire-sale values, she had no trouble explaining that we were wrong. She continued, “The experts do not agree, and for good reason. Fair-value is a regulatory concept that includes the concept of current sale, which is not the same thing as fire sale. The term is defined by the AICPA guide as a current sale means ‘an orderly disposition over a reasonable period of time between willing parties other than a forced or liquidation sale.’”

A few minutes later in the call, in response to a question about whether Allied complied with the Investment Act of 1940, Sweeney again rejected the white paper and adopted the current-sale test: “We apply a current-sale standard, and how we do that is every quarter we actually determine the value of the portfolio company if it were to be sold today in a current-sale. In other words, what in an arm’s-length transaction would a willing buyer pay for a company? . . . If the enterprise value of the company is in excess of our last dollar of capital, we have no need to depreciate a debt security and, in fact, we may have evidence of appreciation for an equity security.”

This was a changed description of Allied’s accounting. Gone was the analysis that it marks investments to what it believes it will
eventually
collect. Gone was the discussion that the current-sale test was difficult or impossible to apply to a BDC. Gone was the notion that it should ignore temporary changes in value and use SBA-styled accounting treatment, where assets are written-down only when they are deemed to be permanently impaired. In fact, Allied retracted almost every description it had used for its accounting that it had made over the past several weeks. Now, suddenly, the current-sale test, which always applied to everyone else, also applied to Allied. Not only that, but according to management, this had always been the case because its accounting was “consistent.”

Sweeney was getting closer to the correct SEC interpretation of the meaning of current-sale, but she wasn’t quite there. The required definition of current-sale refers to the price that an arm’s-length buyer would pay for the
specific security
Allied held and not for the
entire company
, if it were sold. This was confirmed by the SEC’s Doug Scheidt, who had written to the Investment Company Institute and cited an SEC case captioned
In Re Parnassus Investments
, where the SEC found “that a board’s valuation of a portfolio security based upon what the security would be worth upon the sale of the entire company as a going concern, when no such offers were forthcoming, was not determined in good faith.” Certainly, Allied’s management was aware of the distinction of the value of the entire company versus the value of a specific security in that company. Allied cited this case in its white paper. It is the same decision that says investment companies should not value investments at “fire-sale” prices.

While a total enterprise value calculation makes sense for valuing equity securities—you determine the value of the firm and subtract the net debt to calculate the equity value—it does not make sense for valuing debt instruments because debt instruments have limited upside. The most a debt holder can expect to receive is the principal and the interest due. Because of this, debt securities are valued based on the risk of default. For example, if there are two debt securities yielding the same interest rate, the debt security with the lower risk of default is worth more than a debt security with the higher risk of default. If the enterprise value of a firm falls, then the risk of default increases and the value of the debt instrument declines, even when the enterprise value is still greater than the amount of debt outstanding.

Allied’s argument that debt securities are worth par whenever the enterprise value exceeds the debt outstanding is fundamentally flawed and ignores the impact of increased risk of default when the enterprise value falls. It is market practice to reduce the value of debt instruments when the equity cushion shrinks. In Allied’s view, as long as there is
any
cushion, the debt is worth cost. Allied’s comparison of enterprise value to the last dollar of debt in this manner is simply another description of an improper “impairment” test rather than a current-sale test.

When a questioner pressed Allied on its practice of valuing nonperforming loans at cost, Walton backed off and tried to soften Allied’s previous position stating, “We say freely a Grade 4 loan is at par because we think that’s the amount we’re going to get in the value chain and that we’re getting a par return on it. Now, investors when they look at our portfolio can say, ‘Well, gee, they’ve got this amount in Grade 4 that aren’t earning any interest, I think those things are worth a little less.’ They’re free to do that. That’s part—that used to be called security analysis. And then they can say, ‘Okay, I think it should be a little less.’ But that’s not because we’re trying to hide losses. There’s nothing there we’re hiding. We’re saying this is the way we do it.”

Thus, Walton admitted the obvious: The Grade 4 loans, where Allied believed it eventually would recover the principal but not the interest, were not really worth cost even as Allied valued them at cost on its books. Nonetheless, it is Allied’s job to determine how much less they are worth and reflect that on its financial statements. Allied can’t delegate this responsibility to investors as “security analysis.” It is absurd to expect investors to understand by how much Allied overstates its loan values, particularly since Allied does not disclose the performance of the underlying companies, most of which are private.

Next, Sweeney addressed BLX. “The criticism from the shorts seems to be centered on two allegations. First, they say that Allied is taking excessive money from BLX in interest payments and fees. Second, they claim that we have chosen not to consolidate BLX’s financial statements, with the innuendo that BLX is really nothing more than a sham company reminiscent of Enron’s off-balance-sheet special-purpose entity. These allegations are totally baseless. Let’s look at the facts.”

She said BLX had met its business plan goals, was current on its bank debt, had average delinquencies on its SBA portfolio, and received the highest SBA rating for a preferred lender. She said that Allied performed substantial consulting services for BLX, including loan systems integration, marketing, human resources, Web site development, and board recruitment, which more than justified the management fees. (Eventually, we would learn that BLX’s board consisted entirely of BLX and Allied insiders, including Walton and Sweeney. How much did they charge for that board recruitment exercise?) She repeated that 25 percent wasn’t an excessive interest rate to charge BLX because Allied earned nothing more on its equity investment in BLX. This was consistent with Allied’s past comments on BLX.

She continued, “FACT: The consolidation issue is
absolutely
black and white. Since Allied Capital is a BDC, the rules for accounting for investment companies is quite clear. No investment companies may consolidate the financial results of its portfolio companies into its own. Nevertheless, if Allied Capital could consolidate BLX’s results, our reported earnings would have been higher, not lower.”

In fact, Sweeney’s statement must have been knowingly false. In consolidation, Allied would eliminate the unrealized appreciation, fees, interest, and dividends it recognized from BLX and replace them with BLX’s actual earnings. Allied carried BLX at a premium to Allied’s cost, which was itself a large premium to BLX’s book value. Consolidation would have lowered Allied’s earnings and book value by eliminating the premiums.

Certainly, Allied’s management knew that the consolidation of BLX was far from black and white. Indeed, years earlier, Allied consolidated the financial results of BLX’s predecessor, Allied Capital Express, in its financial results. Why couldn’t it consolidate Allied Capital Express’s successor as well? Robert D. Long, a managing director of Allied, spoke to me at Allied’s investor day a couple of weeks later and contradicted Sweeney. He told me that BLX
should
be consolidated. He said that there is a way that they could do that
if they wanted to
.

Our subsequent review of the technical accounting literature indicated that investment companies are precluded from consolidating entities
other than another investment company
. BLX is a lender and could be structured as an investment company. Quite likely, Allied took pains to structure BLX so it wouldn’t have to consolidate it. In fact, part of the motivation to acquire BLC Financial and merge it with Allied Capital Express may have been to deconsolidate Allied Capital Express. Considering that Allied owned substantially all of BLX, guaranteed most of its financing, consolidated a predecessor entity, and considered and often referred to BLX as its small business lending “subsidiary,” consolidation was far from “absolutely black and white.” Further, since investments were being transferred back and forth between Allied and BLX, there are serious doubts as to whether BLX is even operated as a separate company.

During the Q&A, Todd Pitsinger, an analyst from Friedman, Billings & Ramsey, asked how much of BLX’s revenue came from gain-on-sale accounting—a low-quality revenue stream that investors often discount. Sweeney avoided the question and instead gave a lengthy response, which concluded with the erroneous statement that SBA loans last an average of about eleven years. A later questioner pointed out that she hadn’t answered the question and asked for an answer. Management ducked the question a second time.