Financial crises have a convenient upside: They have an uncanny ability to flush out the risky operators, the overlevered, and the downright frauds.
While we might most remember the day Lehman Brothers collapsed and the Dow Jones Industrial Average fell 500 points, we often forget the upside of financial calamity. If not for the financial crisis, Bernie Madoff's customers might still be "earning" their 10% annual returns. And Allied Capital, a financial fraud of the first degree, might still be in business.
In an era defined by the failure of $100 billion institutions, Allied Capital earns just a footnote in history. At its peak in 2007 it had just over $5 billion in assets. It was small, but its lies were big. It was a fraud that should not be forgotten.
Fooling some of the people
Allied Capital gained notoriety when hedge fund manager David Einhorn gave a now-famous speech at the Sohn Investment Conference in 2002. He spoke of various accounting irregularities, and he left the audience with a warning to remember forever: "People who are willing to lie about small things have no problem lying about big things." (Grainy videos of his speech appear on YouTube.)
Allied Capital was a business development company with a long history of producing incredible returns for its investors. Founded in 1958 and publicly listed in 1960, it had an enviable record of paying ever-increasing dividends from its core business of making mezzanine (junk) loans to small businesses. These loans often included equity kickers in the form of stock or stock warrants, creating occasional big wins when the companies it financed grew into big successes.
It grew quietly and in the shadows. It was first listed as an over-the-counter stock, and wouldn't go big until it consolidated all of its businesses and funds into one New York Stock Exchange-listed entity, Allied Capital Corp., in 2001.
After that, it wouldn't take long to attract attention. Einhorn, who had made a mint shorting financial stocks, particularly those that used accounting gimmicks to hide loan losses, quickly latched on to Allied Capital.
Poring over its balance sheet he realized Allied Capital's many investments might have been mismarked. Assets described as performing were often underperforming. In one of the worst cases, Allied Capital carried subordinated debt investments at full value when more senior lenders (those that would have a higher priority to the company's assets) held their investments at zero.
While one mismarked asset might have been an error, the appearance of several mismarked assets suggested this was a companywide problem -- Allied was dramatically overstating its financial condition.
The drama unfolds
The day after Einhorn's speech, Allied's share price dropped by more than 20%. But this was just the beginning. He quickly found that dividend-paying companies are often the hardest companies to sell short.
Investors are quick to defend any company spewing huge dividends. Research analysts at big investment banks had an economic interest in its high share price; as a frequent issuer of stock, the banks earned millions of dollars in fees by underwriting new stock sales when Allied wanted to grow its balance sheet. (Later, Allied Capital hired one bank as a first-time underwriter, but only after the bank fired an analyst who had issued a sell rating on the company.)
Allied had methods to defend itself, too -- at least for a while. As a registered investment company not all that different from a mutual fund or closed-end fund, it was required to pay out 90% of its taxable income to shareholders.
Taxable income is a very favorable measure of income for BDC managers, as it includes realized capital gains -- and Allied, despite its broadly underperforming portfolio, had a few "star students" it could monetize to generate capital gains. In doing so, it could create income seemingly on demand.
The law requires that BDCs pay out 90% or more of their taxable income, so realizing gains necessitated that it pay big dividends to investors. But it also had to defer taking losses from its losers, which would offset the winners.
Allied just had to shift investors' eyes from the industry standard for earnings -- net investment income -- to so-called "taxable income." Investors were willing to go along with it, since for years the company had paid an increasing dividend, which solidified management's credibility.
This trick allowed Allied to survive and seemingly thrive. Einhorn knew Allied was "picking its flowers and watering its weeds" -- selling off its winning investments for taxable income while keeping losers in its portfolio to defer losses. This practice had the unfortunate economic impact of ridding the company of its best investments to create a more-concentrated portfolio of its worst investments.
But the consistent dividend was enough to keep the markets open to Allied. It grew even more by selling more stock as Einhorn held short. From total assets of $2.8 billion in 2002, its balance sheet would swell to $3.3 billion by 2004, peaking at just over $5 billion in 2007.
As Allied Capital soothed investors with a rising dividend, problems were developing behind the scenes.
Einhorn had uncovered massive loan losses at one of Allied's largest portfolio companies. The losses weren't visible, in part because its portfolio company had the same policy of deferring losses for as long as possible and diluting the losses by growing its balance sheet rapidly. It was straight out of its parent company's playbook.
He took these issues to regulators, but they took more interest in short-sellers than in any accounting irregularities and fraudulent behavior at Allied Capital.
Meanwhile, Allied Capital became aggressive in hunting short-sellers. It went so far as to steal phone records of those talking up its weaknesses, hoping to uncover some collusion that might keep the regulators trained on the short-sellers rather than its own internal weaknesses.
The story would go on for years. In 2007, five years after Einhorn's speech, the SEC would finally find that Allied Capital had broken securities laws in how it valued some of its investments. But the SEC allowed the company to continue operating after reaching a settlement in which Allied did not admit any wrongdoing. This story wouldn't end here.
Those who had long believed its managers were starting to take a deeper look at its portfolio marks. In 2008, Einhorn would author Fooling Some of The People All of the Time, which detailed, piece-by-piece, Allied Capital's fraud, the basis for much of this article.
The house of cards truly began to collapse when the financial crisis hit its worst in 2009, requiring more writedowns on Allied's investments on top of writedowns to correct artificially inflated values in prior years. Having dumped its winners to generate taxable income, marginal borrowers that remained in the portfolio faced a rapidly deteriorating economic environment.
Capital markets seized during the financial crisis. Allied Capital's lenders called their short-term financing to the company, and it was in the perilous position of needing liquidity at a time when its balance sheet was both illiquid and salable only at massive discounts. It shopped itself to competing companies and Ares Capital (NASDAQ:ARCC) ultimately won out.
Even its sale couldn't escape financial drama. Prospect Capital (NASDAQ:PSEC) tried to "butt in" on Ares' acquisition; Allied wanted nothing to do with it. Prospect and Allied sparred via dirty press releases, proof that competitors can't avoid the temptation to deliver low blows even when their industry is on its deathbed. On March 26, 2010, Allied Capital shareholders agreed to a takeover that valued the BDC at $3.47 per share, a discount of nearly 90% from its peak valuation in 2007.
Learning from the fallout
Five years after the company folded into Ares Capital, there are plenty of lessons to be learned from the Allied Capital debacle, the first of which is that a dividend, no matter how big, should never be the basis by which businesses are judged. That adage is twice as true in the financial industry.
More broadly, and more relevant today than ever, Allied Capital's story should be a warning for investors who blindly accept managers' use of financial measures when they break from standard practice and convention. This applies everywhere, from tech companies that tout earnings measures excluding stock-based compensation to companies that rely on EBITDA even when depreciation is a very real, very applicable cost of doing business. Often, our acceptance of nonstandard accounting only encourages unfortunate behavior, be it obscene stock option issuance or poor capital allocation.
Finally, and most important, we should accept that investment theses are ever-changing. It would be foolish (little F) to never once consider the bear case once you've gone long. Investment results aren't elections and your net worth statement doesn't have a column for how many times you've been right or wrong. If accuracy were the sole benchmark for investment performance, venture capitalists would be beggars instead of billionaires and Donald Trump would be just another guy with a bad haircut.