Editor's note: This story has been updated to note that it was Jim Brickman, not David Einhorn, who worked with Charles Gunther in writing a negative report on Allied. The Fool regrets the error.
A hidden war
For the past several years, Allied Capital (NYSE: ALD ) has been in a war of sorts, pitted against several high-profile detractors and hedge fund managers who are shorting the company. Former Fool Jeff Fisher looked at the tempest in a teapot way back in 2003. The allegations have been ugly at times, but Allied Capital's business has remained strong throughout. This is a classic case in which focusing on the business has paid dividends not only for management, but for shareholders as well -- shorts need not apply. The one unfortunate result of all this fearmongering is that potential investors have missed out on some outstanding returns because of the perversity of the allegations.
It began in 2002, when famed hedge fund manager David Einhorn told a group of money managers at a conference that he was shorting Allied Capital, primarily because of concerns about how the company valued its portfolio companies. Allied Capital values its portfolio investments based on the likelihood of collecting fair value for the company when it goes to exit its investment. Einhorn believes that the company should "mark to market" its portfolio companies, meaning that the valuations would immediately reflect any deterioration or improvement in the investments -- similar to the way Enron accounted for much of its illegal gains. When Allied writes an investment down, it typically does so to maximum recovery value, which is at some point off in the future. Einhorn thinks that investment should be written down even further, to fully reflect the present value of the investment.
Even American Capital's (Nasdaq: ACAS ) CFO, John Erickson, commented that Allied Capital's valuation method is neither aggressive nor conservative, just a more venture-capitalist/private-equity way of doing things.
For short sellers, the primary targets were Hillman Companies and Business Loan Express (BLX), two of Allied Capital's largest investments at that time. Both companies had once made up substantial portions of Allied Capital's portfolio. Given the companies' size, short sellers focused on them, betting that if these two failed to meet Allied's valuations, a host of smaller investment valuations would be inaccurate as well, leading to a collapse in the portfolio valuations and eventually the critical dividend payouts.
The battlefield expands
Several others, including columnist Herb Greenberg (formerly of TheStreet.com, now working for Marketwatch.com) and Jim Brickman (a noted Yahoo! poster), also continued to raise concerns regarding Allied.
Greenberg has been universally negative on Allied Capital for several years in many articles. Despite a complete lack of evidence, he is convinced that in 2004, Allied Capital broke into his phone records at Verizon (NYSE: VZ ) . Is anyone surprised that Greenberg continues to cover Allied Capital with extreme prejudice, as noted in his recent headline, "Allied Capital seeks to 'clarify' news about fraud charges"?
Other individuals, including Brickman and Einhorn, have had their phone or bank records accessed without their approval. Einhorn wrote a letter to Allied's board in 2005, and again in September 2006 after the Hewlett-Packard (NYSE: HPQ ) furor, asking the board to look into the pretexting incident. Both times, Allied Capital's board replied that they had looked into the incident and found no evidence to support his claims.
Brickman not only shares information with Einhorn but has also worked with Wall Street analysts to publish negative reports on the company. In 2004, he helped Wachovia Securities analyst Joel Houck craft questions for Allied; Houck ultimately dropped coverage of the stock because of perceived inadequate disclosures by the company. Brickman also worked with Farmhouse Equity Research analyst Charles Gunther (who was also a victim of the pretexting incident above) to write up a negative report on the company. Gunther even mailed the report to Brickman a week before it was published, although Brickman denied seeing the report at that time because of travel constraints. In the Farmhouse report, the analyst eventually recanted the negative report, which asserted that the dividend was in danger of being cut in 2005 (the dividend is one of the major reasons investors are fond of BDCs).
Still, this ruckus didn't go unnoticed. Perhaps in part because of Brickman's 2004 request that Texas Sen. John Cornyn write to the SEC regarding Allied's BLX investment, the SEC met with Brickman to discuss the troubled portfolio company. Subsequently, the SEC began investigating Allied a few months later, and the U.S. attorney's office in Washington opened its own investigation a few months after that. To date, these investigations have cost Allied roughly $40 million in legal fees.
Why the war is over
The valuation arguments presented by the short sellers have largely been focused on two of Allied Capital's largest investments: Hillman Companies and Business Loan Express.
Hillman Companies was the first test for Allied Capital. The manufacturer of key-making equipment and various other hardware components was first acquired by Allied Capital in early 2002. By late 2003, its fair-market valuation made up about 7% of Allied Capital assets at $186 million. Critics argued that the business was a terrible one with low returns, and valuing the business at 7 times EBITDA at the time was far too high. Needless to say, Allied Capital passed this first test, unloading the Hillman Companies to a private equity firm in early 2004 for $510 million, a $145 million gain.
Business Loan Express is a more contentious issue. The company makes government-backed loans to entrepreneurs under a program managed by the Small Business Administration. Critics have dogged the company for years for poor underwriting skills. Defaults are in the 9% to 12% range, depending on what exclusions one uses according to BLX's data, which was provided to The Wall Street Journal (subscription required) in 2005. Those guidelines, however, are still within SBA tolerances, and the company points to its overall low loss rate of 1%, which stems from excellent collection efforts and sales of collateral on repurchased loans.
Recent news concerning the indictment of an ex-employee at BLX who allegedly falsified $77 million in loans is cause for concern, but these bad loans are only about 3% of the portfolio, which totals about $2.7 billion. Keep in mind, though, that even if BLX is a total loss (which is extremely unlikely), the impact against Allied would be minimal, not only because of the small size of the investment, but also because of the $540 million in realized gains that ensure the dividend won't be cut.
When Allied first acquired BLX in 2000, it was about 10% of Allied's portfolio. The company is now only about 6.2% of Allied's portfolio, or $284 million. This is down substantially from Allied's valuation of the company at the end of 2005, which was $357 million. As Allied continues to make substantial investments every quarter -- $629 million last quarter -- that percentage will decrease, and the investment will be even less material to Allied's results. Even so, this is a company that is sought out by other companies for its managerial expertise, and it has extensive experience in turning around troubled organizations. It is clear the story is not over yet, but the results are unlikely to impact Allied Capital's strong business prospects.
Investors should look at the recent price drop as an opportunity to build a position in Allied Capital. From this investor's perspective, Allied Capital has won the war decisively.
For more business development company coverage:
- American Capital: An Investing Gorilla
- An Investor's Guide to Business Development Companies
- A Savage War for Investment Returns
American Capital is an Income Investor recommendation.
Fool contributor Stephen Ellis does not own shares in any companies mentioned. You can view the stocks he owns and check out his 99th-percentile ranking in Motley Fool CAPS, the Fool's new stock-rating community. The Motley Fool has a disclosure policy.