Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (9 page)

Sweeney defended the valuations by arguing that when Allied exits investments, it achieves the most recent carrying value. According to Sweeney, this proves that the investments couldn’t be mismarked and shows that “we are pretty good when it comes to fair-value accounting.”

Loeb wasn’t done. He asked if Allied’s business resembled a closed-end fund. Walton responded that Allied is actually an operating company, providing significant managerial assistance to its portfolio companies. The transactions are privately negotiated, and Allied has board observation rights or serves on the board in every deal. Allied provides significant assistance in financing, mergers and acquisitions (M&A), employee benefits, marketing and all sorts of areas to help grow the business. “So our business is not a passive buy-and-hold and trade business,” Walton said. “It’s an actively managed portfolio . . . deeply involved with each management team to grow the business. And it’s a very hands-on process. We have thirty-five investment officers handling 130 companies.”

The next private-equity investor I meet who says he just puts money in and sits on his hands will be the first. They all say they provide services and add more than money to their investments. Still, they realize the funds they manage are investment vehicles, and few, if any, would consider themselves to be “operating companies.”

The time-consuming nature of negotiating and structuring the entry and exit of each investment and looking for new opportunities suggests that the thirty-five investment officers didn’t have a lot of time left to make large contributions to marketing and human resources at 130 companies. In 2001, fees totaled $46 million, or $1.3 million for each of the thirty-five investment officers providing part-time assistance. At those implied rates, it was no wonder most of the fees came from controlled companies that were not deciding for themselves whether to engage Allied for auxiliary services.

“That wasn’t really my question,” Loeb said. “The observation was that—what compelling argument would you make to invest in your company?”

“Dividends,” Walton said.

Now we’re at the heart of the matter. Allied has paid a steady or rising dividend for over forty years. It has paid the dividend whether it had profits to cover it or not. Allied’s dividend is a holy covenant between itself and its shareholders. Its payment proves to them that all is well. After all, you never have to restate a dividend.

Just as the Elán bulls had argued that Elán was a lousy short, because it would
never
miss its earnings forecast, the Allied bulls argue that Allied’s dividend is unlikely to be cut regardless of whether it deserves to be cut. They raise the same question: “How are you ever going to get paid on your short if Allied
never
cuts the dividend?” Of course, when Elán was ultimately revealed to be a fraud, it did miss the earnings forecast, and the short worked out well.

As bizarre as this sounds,
Allied’s “dividend” is not really a dividend
. Traditionally, a dividend represents excess profit that a company pays to shareholders because it does not need to retain the capital in its business. Though Allied’s “dividend” of about 8 percent is about three times the average yield in the S&P 500, it isn’t a “dividend” in the traditional sense. Traditional companies that pay large dividends do not generally issue fresh equity because the dividends reflect an unneeded surplus of capital. However, Allied does not have excess capital. So, its “dividend” is not paid from surplus it doesn’t need to retain in order to maintain or grow its business. In fact, Allied routinely sells freshly issued stock to satisfy its ongoing need for additional equity.

Technically, Allied’s “dividend” is a tax distribution. As an investment company, as long as it distributes its taxable earnings to its shareholders, Allied does not pay corporate taxes. This is the same tax regime practiced by mutual funds and every other type of U.S. investment company. When mutual funds pay large annual tax distributions, its investors are unhappy. In fact, a good mutual fund seeks to minimize its tax distribution by keeping its winners and selling its losers. No mutual fund strives to smooth and grow its tax distribution. No one would value a mutual fund based on the yield implied by its tax distribution.

As a stroke of investor-relations genius, Allied breaks its tax distribution into four quarterly pieces and calls them “dividends.” Wherever I refer to Allied’s “dividend,” “tax distribution,” or just “distribution,” I am referring to the tax distribution Allied calls its “dividend.” Unlike almost every other investment company, Allied principally judges itself by how well it maximizes its taxable income rather than by its investment results. As a result, it sells its winners and keeps (and often supports) its losers. In the money management industry, this is known as “picking your flowers and watering your weeds,” and it’s a recipe for disaster. The
maximize taxes
strategy, of course, increases Uncle Sam’s take. Allied has taught its shareholders to pay taxes and like it!

Later, Walton said: “We’re a dividend company that wants to grow the dividend 10 percent a year.” Then Walton addressed me. “I’d like to just point out to Mr. Einhorn that he’s so generous by giving up half his profits,” he said. “We’ve got 85,000 retail shareholders that depend on the dividend. We really operate the business for dividends. I think that’s a pretty good social purpose, too. . . . We find it unusual that somebody gets up and gives a speech about a company who never bothers to talk to management. I think most informed investors would appreciate some time spent with us so they can talk these things through unless you’re simply trying to develop the short thesis to scare people and make a quick buck and move on. I don’t find that a very high social purpose. Maybe other people do.”

Walton and others at Allied
knew
we had talked to management and gone through the issues with them at length. Their responses on the conference call weren’t different from what Sparrow and Roll told us. They knew there wasn’t any misunderstanding, and they had no interest in calling us to work through the issues to try to show us we were wrong. Instead, they desperately needed people to question our motives and to think we didn’t do our homework.

Walton responded to a question about how much of the distribution is covered by ordinary income. “For the last four years, our exclusive strategy is to build the interest and fee income from the portfolio to provide more ordinary income to cover the dividends.” He continued, “Last year, our ordinary taxable income was about 90 percent of income, which we think provides a lot of stability for the dividends. We think capital gains are great, but they’re less predictable, and so, therefore, we try not to build that into the dividend growth model.”

Beginning with that quarter, Allied has been unable to sustain the 10 percent distribution growth it projected, and ordinary income never again came close to covering the distributions. Instead, Allied shifted to a capital gains strategy. All it had to do was make shareholders forget Walton’s words and convince them that capital gains are actually predictable.

Then Walton finished with an Orwellian wrap-up. “We’re delighted to talk about our business and we’re committed to transparency and full disclosure,” he said.

Allied’s entire strategy is extensive disclosure on some things, but little disclosure on what a skeptical investor might really wish to know. For example, Allied provides terrific detail of its industry and geographic investment diversification, but barely a word about the business results, prospects or valuations of its individual investments.

It occurred to me that people who are willing to lie about
small
things have no problem lying about
big
things.

CHAPTER 7

Wall Street Analysts

Coming out of the conference call, I felt great. Allied management did not make any points that seriously challenged our analysis and continued to repeat what they had told us previously. Their comments were convoluted, their tactics desperate. When a reporter for
Dow Jones Newswire
called, I told her, “They talked around all my issues without really addressing any of them.” I decided to sell more shares short.

Starting that day, a number of law firms began filing class-action suits, repeating the criticisms I had made in the speech. Though Allied and its supporters claimed Greenlight was behind the lawsuits, we had nothing to do with any of these lawsuits, and we were surprised by them. The lawyers were simply reacting to the news of the day and rushing to court hoping to earn fees. It seemed Allied wanted people to sympathize with them as victims of an intricate, though, in fact, imaginary conspiracy.

Later that day, Allied’s investment banker, Merrill Lynch—which earned millions in fees underwriting Allied’s recent equity deals—published a report titled “The Song Remains the Same.” Though our view was outside Wall Street’s thinking about Allied, the company and its supporters pretended that Greenlight offered nothing new, so no one needed to pay heed. Of the conference call, Merrill opined, “The company provided meritorious defenses to all the criticisms leveled.”

“As a business development company, the company is required to mark its investments to long-term value, and disclose these investments to investors quarterly in their SEC filings,” the Merrill report declared. “From time to time, the company has had investments in publicly traded companies (equity and debt) where the mark to market on the investment differs from where the investment trades in the market (or where a deal has been announced). There have been both undermarket gains (such as WyoTech currently) and debt and equity that has traded below where Allied has carried it (such as Velocita debt currently).” Then, Michael Hughes, the Merrill analyst, underlined his next sentence for emphasis. “The nuance here is that Allied is required to mark to long-term value, not mark to market.” That would have to be some nuance, because it was clearly wrong. As I said in my speech, the Merrill Lynches of the world would defend the stock to the death.

Indeed, the next morning Wachovia resumed coverage of Allied with a “Strong Buy” rating and a $29 price target. Joel Houck, its analyst, published a report that might as well have been written before my speech. It talked about the business model, Allied’s long history, and how cheap the stock was. The report discussed how the business model evolved after 1997 when Walton became CEO and Allied’s predecessors merged. Allied made larger deals, raised capital, and took more control positions, such as BLX, Hillman, and Wyoming Technical Institute (Wyotech). When Houck presented his recommendation to the Wachovia sales force, he also said that I “didn’t raise anything new.”

At my request, a few hours later we had a call with Houck. Houck told us that he had drilled down on our issues for twelve to eighteen months, and while Allied’s transparency isn’t where it needs to be, the weaknesses in tech-oriented names are where their long-term approach to valuations doesn’t really hold up well. Because the transparency isn’t good, he can judge only the portfolio-wide results, and, as Sweeney said, since exit events occur at valuations consistent with Allied’s most recent marks, there is no reason to question the portfolio valuation as a whole.

While he acknowledged that Velocita, Loewen Group, and NETtel valuations are “almost indefensible,” he thought there was offsetting upside in the valuations of Hillman, WyoTech, and BLX. I pressed him on his admission of “indefensible” valuations. He tried to clarify, “What I meant was, absent the proprietary information Allied is sitting on, the valuations are indefensible.” I pointed out Velocita is a public company with SEC-filed financials. What proprietary information could they have to justify carrying it at cost at the end of last year?

He asked if I had seen the internal documents Allied used to value its portfolio. I told him that I hadn’t, but if he could show us a document to justify the year-end valuation of Velocita, we would publicly recant our entire analysis. He said he would pass that along. He also said that the investment company valuations allow the company a hold-to-maturity approach to valuation. I called him on that by pointing out that the Investment Company Act of 1940 doesn’t permit that. Suddenly, he didn’t seem to know everything. “What does it say?” he asked.

I said the Act says you have to use fair-value. He quibbled over the difference between “fair-value” and “market value,” so I asked him to explain the distinction.

He responded, “Value is a tricky concept, David.”

Then, I pressed him on his claim that I had not said anything new. I pointed out that he didn’t hear my speech and he hadn’t called to find out what I said. He said that the audit letter was a new issue, but it was “easily dismissible” because the Audit Guide had changed. I challenged that, and he said he would look into it further. Then, he asked me what I thought was new. I questioned how the portfolio survived a recession without significant credit losses. I compared Allied to a high-yield bond portfolio and pointed out that Allied’s loans were generally riskier because the companies are smaller than high-yield issuers and had less access to capital. According to Allied, it had performed even better than Finova, a senior lender.

He said, “Finova was fraud.” In fact, Finova was not a fraud, just a company that mismanaged its credit and liquidity risks.

“How do we know this isn’t fraud?” I asked him.

“David . . ., nobody knows. Nobody can say definitively whether it is fraud or it isn’t fraud,” Houck acknowledged.

“How do you know Finova was fraud?” I asked him.

“Well, you know it was fraud after the fact,” he replied.

Then, he told me we had spoken to the “wrong people” at Allied. This continued the story that
we hadn’t done our homework
. I told him that we went over our issues through normal investor-relations channels. He said that we needed to talk to Sweeney, not Roll. “Joan Sweeney is the chief operating officer, has her finger on the pulse of all these companies,” Houck said. “Do you know where she was before Allied?”

“Where was she before?” I asked. “I don’t know her history.”

“She came from the SEC Division of Enforcement,” Houck said. “I mean, look, anything is possible: SEC investigation; I hear what you’re saying, not a good event. But I’ll take my chances that Joan Sweeney knows the. . . rules and regs and is going to come out on the right side of the issue given her background.”

This wasn’t just Joel Houck speaking. This was Allied’s story. Repeatedly, I heard from shareholders and short-sellers Allied’s whispers that Sweeney’s experience at the SEC Division of Enforcement made it implausible that she would break rules, or, more cynically, if she did, that the SEC would give her a pass.

Even though my wife wrote for
Barron’s
, I didn’t have a lot of contact with journalists at other publications. Obviously, because of my wife, I could not bring the story to
Barron’s
; the editors and I had a policy that I would not discuss investments with anyone on the staff. I had recently met Jesse Eisinger, who wrote the excellent story about the fraud at Elan for
The Wall Street Journal
. Though the
Journal
is owned by Dow Jones, which also owns
Barron’s
, the publications are run separately. Eisinger told me to call if I ever had a story. I called and arranged a meeting, in which James Lin and I spent a couple of hours describing Allied. Eisinger expressed interest and asked for an exclusive until his upcoming vacation, which was to start in a few weeks. We agreed.

The next week, Hughes, the Merrill Lynch analyst, wrote another supportive report titled “Allied Capital Auditor’s Opinion—Much Ado about Nothing.”

Allied Capital’s stock price has been on a roller coaster for the last few days as the market sorts through a series of allegations including improper investment valuation procedures. During this period we have written that we believe these allegations are unfounded and uninformed and have attempted to produce as much factual rebuttal as possible. As outlined below, we believe we can now factually dismiss the allegation of a less thorough audit.

The report continued:

The AICPA (American Institute of Certified Public Accountants) audit guide was revised in May 2001. A key revision of the guide: auditors are no longer instructed to specifically comment on the reasonableness of a company’s investment valuation procedures if they find them acceptable. And the only audit opinion provided for use if the fair values are reasonable is exactly the audit opinion used in Allied’s report.

We knew this was wrong. James Lin got the pages from the Audit Guide that supported Merrill’s research. Merrill gave James pages with a fax header from BLX. The pages with the old language came from the 1993 Audit Guide. From this, Merrill had no way to determine that the change occurred in May 2001. I re-examined the Merrill report closer and saw that Merrill had footnoted the 1993 Audit Guide in an eye-doctorish microscopic font. The footnote indicated that Merrill must have noticed what BLX sent them and wrote the report anyway—proving that Merrill willingly participated in the spin job.

Greenlight’s auditors determined that the actual Audit Guide change occurred in 1997, not 2001. I complained to Hughes’s boss at Merrill about his apparent bias. His boss told Hughes to call me. Rather than acknowledge that Allied’s management misled him and reassess Allied’s credibility, Hughes dug in his heels. He asked, what if they argued that Andersen missed the change in the 1997 Audit Guide and only put in the new policy in 2001? I had the impression that Hughes wanted to create a story we could not refute. It seemed to me that it didn’t matter to him whether it was true or not; he had no interest in determining and analyzing the facts. I told him I knew this was wrong. Arthur Andersen had also been Sirrom’s accountant and made the same change to the audit language at Sirrom in 1997.

Then I turned to the point from his first report where he emphasized that Allied is supposed to mark its portfolio to “long-term value.”

“You’re going to have me on this one, because I know the technical language is fair-value,” he said.

We then debated whether it was permissible to carry Velocita bonds above the publicly traded market price. I told him, “You do not have an ability under Allied’s own policies as explained in the 10-K when there are quoted market prices to carry it at a premium.”

He replied, “It’s never been my reading of the ‘K,’ but I’ll have to get a lawyer to look at it.”

“I can read it to you verbatim if you like,” I offered. “Do you want to know what it is?”