Letter #42: David Einhorn (2002)

Founder of Greenlight Capital | 2002 Ira Sohn Speech on Allied Capital

Hi everyone! Due to popular request (and a few persistent individuals), I’ll be restarting this newsletter, but with a few changes. Most notably, rather than sending “A Letter a Day”, I’ll be sharing a letter or transcript twice a week, once on Tuesday afternoon (2:22pm) and once on Saturday morning (6:06am). Second, I’m expanding the scope of the newsletter to include a broader range of subjects, but still focused on thought-provoking investors (across venture, hedge funds, and private equity), founders (not just tech), and operators (sales, marketing, product, etc). Lastly, I’ll be limiting my commentary so it’s a smoother reading experience and you can read the work as is. (If you’d like to see my notes or trade thoughts, shoot me a DM on twitter!)

Today’s transcript comes from 2002, when Greenlight Capital Founder David Einhorn gave a now-legendary speech about Allied Capital at the Ira Sohn Conference. (Transcription and any errors are mine.) His speech was “so compelling that the next day, when the New York Stock Exchange opened for trading, Allied’s shares remained closed. So many investors wanted to sell or short the stock that the NYSE could not balance all the sell orders to open Allied’s trading in an orderly fashion.”

I hope you enjoy this speech as much as I did!

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Transcript

I guess I'm the third David to go here in a row. I was a little bit nervous about speaking in front of such an audience today. So last night, I finished preparing my remarks and I went to my wife to practice them for her. And let me tell you that at the end of my remarks, which lasted 15 minutes, she was snoring. So don't feel bad, because what I'm going to tell you today is a little bit more technical.

I'm gonna go into just one idea, and I'm gonna go into it in quite some depth. But even though my wife was snoring at the end of the remarks, it didn't prevent her from having 20 minutes of suggestions.

Napoleon was sitting with his advisors, and his advisors were recommending a new general to lead a new military campaign. The advisors told Napoleon that the prospective general was very good with the men. He was very smart, and he had excellent tactics. Napoleon looked at his advisors and said, Yes, but is he lucky?

In our business, luck has a lot to do with things, but so do good tactics. One tactic that I use that I think has been a good tactic for me is selling short. When I sell something short, I'm not trying to create a hedge. I'm trying to create a profit. Each year, we've been profitable on our short sales. Our average return on capital on short selling over our six years has been 30%.

We do this by identifying stocks that are both overvalued and deteriorating. In many cases, there is something wrong that we have unearthed that is not widely understood in the market. About once a year, we seem to find a financial institution that has large problems. Last year, we had Conseco, the year before that was CompuCredit. Before that were Sirrom Capital and Resource America. Each of these shares fell over 80% from the time that we shorted them.

Today, I want to tell you about our newest sort of financial short that falls into this category. I don't know whether it will fall 80%, but I believe it falls into this group as it has very similar characteristics. The company is called Allied Capital. It goes by ALD on the New York Stock Exchange, it has a market value of about $2.6 billion, it goes for about twice book value. Allied is what's known as a registered investment company, or a RIC. As a RIC, it pays no taxes, and it passes through its earnings each year as a dividend, sort of like how a REIT does. It's limited to one times financial leverage in order to qualify as a RIC. So since they have to pay out the earnings as a dividend, they are limited in the amount that they can grow. The way that they can grow is by selling equity at a higher multiple of book value. And that's how they're able to then lever that equity and continue their growth. That's the only way the book value per share grows. As a result, they're constant clients of Wall Street. And I'll tell you, no matter what I say today, the Merrill Lynches of the world are going to defend this stock to the death in the foreseeable future.

What they do is, they make mezzanine loans to private companies, and unrated first loss tranches of commercial mortgage backed securitizations, or CMBS. Since they are a RIC, and not a bank, or even an unregulated specialty finance company, they do not have to set up loan loss reserves in advance of credit defaults. Instead, they have to mark each investment to fair value on a quarterly basis.

The good news for us, as you will see, is that they have to tell us the value of each investment in the back of every 10Q and every 10K. So what we have here is a closed end mezzanine fund that's trading at two times net asset value. But let's talk about some of the specific investments. It's very hard to find information about most of the investments because the companies are private that they invest in. But we have, through public sources and market information, been able to get some information on a few of the companies.

And I'd like to start by telling you about some of them.

First one I want to talk about is an entity called Velocita. Velocita is an investment that was sponsored by Cisco. We believe that Cisco holds an investment in Velocita's secured revolver. It is senior to the publicly traded bonds that Allied owns. In the October quarter, we understand that Cisco wrote down its investment in Velocita to zero. At year end 2001, Allied Capital carried its investment, which is subordinated to the Cisco investment, at par. And it carried the warrants at cost. Even after they took down the writedown in the March quarter, they continued to value their investment in Velocita at about 40 cents of par even as the debt trades today at about two.

Another investment is the company called Startec Global Communications. Here they have $20 million invested that they carried at par through 2001. They even increased their investment in the company in June, by an additional $15 million, despite the clear evidence that Startec was falling. Arthur Andersen's auditor letter to Startec in the 2000 10K said that the company has suffered recurring losses from operations, has a net capital deficiency, and working capital deficit. These facts raise substantial doubt about the company's ability to continue as a going concern. Similar language was repeated in each subsequent filing with emphasis on the significant risk that Startec would miss a critical November interest payment. Allied did not write down its investment in Startec until the fourth quarter of 2001, after which Startec had already filed for bankruptcy.

NetTel filed for bankruptcy in late 2000, and an auction of its assets was held in December of 2000. Allied valued its debt investment in NetTel at par in the third and fourth quarter of 2000. They continue to value their investment in NetTel at about 40%. They claim that the value recovered recorded on NetTel investment represents its estimate of what its claim of NetTel's assets are worth, and it believes it will receive the money. This, despite the fact that a chapter seven liquidation sale was completed over a year ago.

Next up is the Loewen Group. Allied owned publicly traded high yield bonds throughout the Loewen reorganization. They carried the bonds at a premium to where the bonds traded and a premium to the recovery value estimated in the disclosure statement. We asked the company why they did not use the market value to value the bonds. The CFO informed us that the trading market was thin and not representative or where willing buyers and sellers would discover value. Based on its own analysis of Loewen's situation, Allied had concluded that its valuation was appropriate. Unfortunately, once the bonds were restructured and reorganized security prices have demonstrated that not only the market and the disclosure documents were too optimistic, but certainly Allied as well.

In my opinion, when we find a few mismarkings like this in a portfolio, it suggests problems in the general behavior of the company, and it puts the value of the entire portfolio in doubt.

Another source of income for Allied are what we will call controlled investments. By this I mean these are investments where Allied owns all or almost all of the equity. In ordinary GAAP accounting, as applied to operating businesses, when you own a controlling investment in a company, you have to consolidate the results. Transactions between you and your wholly controlled subsidiary are called intercompany transactions and they are eliminated in the consolidation.

Not so in Allied’s RIC accounting. They do not consolidate these controlled investments, and they do not eliminate the intercompany transactions from the consolidated results. The creation of these wholly controlled investments is a relatively new practice for Allied over the last couple of years. One thing Allied does do with these controlled investments is provide services, such as investment banking, for which they charged fees.

In 1999, Allied had no controlled investments. It generated and recorded fee income of around $6 million, which was flat with fee income in 1998. In 2000, fee income had grown to $13 million. Last year on the P&L, fee income was $46 million. That's nice growth. According to the CFO, however, $29 million of the fees come from the controlled investments.

One of the controlled investments is a company called Business Loan Express. Business Loan Express makes small business loans under the SBA. Even though Business Loan Express is 100% owned by Allied, which is a public company, Allied provides no data on Business Loan Express. We don't know how much it earns, we don't know how its portfolio of risky small business loans has performed during the recession. We don't even know how large the portfolio is, or how much leverage it uses. What we do know is that in addition to the fees that I just mentioned, Business Loan Express pays Allied a 25% rate of interest, or $20 million a year, on an $80 million investment that Allied has lent to Business Loan Express. Since Allied owns all of the equity, I guess they can decide what the interest rate on the loan will be. And what they charge in their fees.

But in my opinion, this is the sort of thing, those sort of left pocket to right pocket, that explains why intercompany transactions are eliminated under most accounting systems.

I don't know of any finance companies like Business Loan Express that are able to make good profits when they're forced to borrow money at 25%. I also don't know of any other companies that Allied charges 25% for its money.

There's another Allied-controlled investment. It's called Hillman, which has a $40 million loan that Allied has set the rate at only 18%. This, of course, is in addition to whatever fees Allied charges Hillman. So there's another $7 million of intercompany income. Let's just talk now for a minute about how Allied generally values its portfolio. As I mentioned before, Allied does not provide for specific loan loss reserves. Instead, it marks its value to fair value as determined by the Board of Directors under the supervision of its auditors.

So let's see what the auditors say. I'm going to read from the audit letter from the 10K that came out after the year 2000. So this is one year dated. I'm going to pick the third paragraph of the audit opinion, where it says, As discussed in Note 2, the consolidated financial statements include investments valued at $1.78 billion as of December 31, 2000, and $1.2 billion as of December 31, 1999. This is 96% and 95%, respectively, of the total assets, whose values have been estimated by the Board of Directors in the absence of readily ascertainable market values. “We have reviewed the procedures used by the Board of Directors in arriving at its estimate of value of such investments, and have inspected the underlying documentation. And in the circumstances, we believe the procedures are reasonable and the documentation appropriate. However, because of the inherent uncertainty evaluation, the Board of Directors estimate of value may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material.”

But now let's turn to the most recent 10K filing, where we have the audit from the year that came in at the end of 2001. And this paragraph reads substantially the same as the paragraph I just told you, except the numbers have changed a little bit. Except there's one sentence that has disappeared. The sentence that disappeared, it was the sentence that said, "We have reviewed the procedures used by the Board of Directors and arriving at its estimate of fair value of such investments, and have inspected the underlying documentation. And in the circumstances, we believe that procedures are reasonable in the documentation appropriate."

So apparently, now, the auditors maybe didn't review or inspect the underlying documentation, or the procedures. Maybe they don't think the estimate of the value of such investments is right, or they've inspected the underlying documentation. Maybe they don't know if they've arrived at the correct value, or procedures are reasonable under the circumstances. We asked the CFO about this, and to explain why did the audit language change. And what she told us was that the language change was dictated by a change in the audit guide.

So we consulted our own accountants, who consulted the various editions of the audit guide. And they were unable to explain any change in the direction for what the language should be from one audit guide to the next over the last couple of years. So it must be another explanation.

I think the explanation actually is, is I forgot to tell you the auditor here is Arthur Andersen. And at the end of 2001, they may not have wanted to feel quite so comfortable about some of these valuations. But that's just one man's speculation.

Let's move on to the CMBS portfolio for just a moment. Here we have a $700 million CMBS portfolio. They own first loss tranches of highly leveraged securitizations. Most of the securitizations were done in the last three years. So the portfolio is unseasoned. Allied carries the whole portfolio at cost. They cite the low delinquency rate of the underlying mortgages to back up their valuation. My only observation is that national office vacancy rates have about doubled in the last year and rents are falling. It may take a while before this leads to landlord delinquency, defaults, and ultimately credit loss. But it seems to me that the portfolio of non-rated first loss tranches in highly levered CMBS pools that were mostly underwritten just ahead of the recession, is, let's just say, a dicey proposition.

Back to the finance portfolio. This is the main part of their business, and I told you about some of the loans and how they were carrying them before. What Allied does is, they have a five point rating system. They rate the loans on a scale of one to five.

A loan rated one means that they expect to make a gain on the equity component of their mezzanine investment. Here they do their own valuation, comparable company analysis, discounted cash flow, whatever, and they figure out what the warrants are worth, and they mark them up to what they think the fair value is.

Loans rated two are performing as expected, and they're carried at par.

Loans rated three are on what they call the watch list. Companies on the watch list are probably performing below plan. They may have tripped financial or have other covenants, they may require fresh money from Allied, but Allied does not believe that it will lose any principal or interest. Again, this may be based on their own DCF or comparable company analysis. Allied carries these loans at par. We asked why grade three loans are not written down. Since there has been deterioration, presumably the loan is worth less than it was on the day that it was underwritten. According to the Head of Investor Relations, investments are marked down only when we believe that there has been a permanent impairment in the value. Once we mark it down, we don't believe we will recover the investment.

I wish I could only mark down my investment losers when I believed that there was a permanent impairment of the value. I interpret her answer to mean that the company marks the loan to the maximum recovery value, rather than what I would view, at least, as fair value. In my experience, when a credit underperforms, even if I think it will pay all of its interest and principal, spreads widen, debt instruments issued at par become worth 95 cents, or 90 cents, or less. Anybody wants some WorldCom?

This does not seem to happen at Allied, where investments continue to be marked at par. In fact, in the most recent quarter, Allied announced that they had bought senior debt from the banks and companies where they own the mezzanine debt. Allied was enthusiastic that they were able to buy this debt at a discount! It seems to me, if the senior debt is available at a discount, the sub debt is in worse shape. It appears that Allied continues to mark this subdebt at par in these cases.

Loans rated four means that allied expects to lose some interest, but no principal.

Loans rated five mean that the principle is impaired. These loans get written down, I guess, to the value they expect to eventually recover. According to the company IR lady, there is no time limit on our investments. We could keep them at some level of value as long as something is being done to try to recover the investment. They cite this as a positive benefit, unlike a bank that has to recognize chargeoffs to satisfy regulators. I asked for an example of an investment where their patience paid off. The company could not cite one loan in the last three years where they carried the loan at a discount, they were patient, and they eventually got a better recovery.

Last year, during the recession, Allied had credit losses of around 1% of the portfolio. This is about the same as it has been in previous years. They must be great underwriters. According to Moody's, last year, 12% of high yield bonds defaulted. The five year average default rate is about 6%. I would argue that Allied's portfolio is probably at least as risky as high yield bonds. The companies Allied lends money to tend to be smaller than high yield issuers, and almost none of them do have access to public equity markets. Needless to say, I am suspicious of the low credit loss reported by Allied given the types of loans they make and the performance of other portfolios of loans in the recession. Did anyone notice how Finova's portfolio performed?

The valuation here of the bull case is supported by the dividend yield. As I said, the company pays out the earnings as a dividend. The $2.20 that they pay out right now provides a yield of over 8%. Part of the question is, How do they generate the dividend? Last year, they paid $180 million in dividends. About $65 million came from non-cash or PIK interest in dividends from companies that they invested in.

Now, there's nothing wrong with non-cash interest, provided that you're comfortable that the money will be collected and the portfolio is being fairly marked. As we have seen, this requires a leap of faith. I want to point out now that if you generally don't recognize impairments until loans become delinquent, and if you do not require cash interest in the first place, you may wind up understating the delinquency statistics, and you may not properly account for troubled credits.

Anyway, since Allied has to pay out all of its earnings as a dividend in order to fund the 65% shortfall between the dividend requirement and the earnings, the cash earnings, if you would, Allied is ultimately limited in how much it can borrow. It must eventually sell equity in order to raise the capital to pay the dividend. When the dividend is paid from the proceeds of newly sold shares, in effect, the company is taking money from new investors to satisfy the income requirements of the existing investors. There's a name for that.

The sustainability of this, of course, depends on the company's ability to maintain its premium stock price. So adding up what we have here is $65 million of PIK interest in dividends, $29 million of intercompany fees from controlled investments, $27 million of intercompany interest, we've now explained 121 million, or two thirds, of the earnings/dividend. How juicy does that 8% dividend yield feel now?

I'm grateful for the opportunity to share this idea with you guys today. I believe Allied is a good short idea. I also think that the Tomorrow's Children's Fund is a wonderful cause. So I had an idea, and I'd like to just have the pleasure to announce that on behalf of my partners Jeff Keswin, Vinit Sethi, and Nelson--actually, why don't you guys stand up just for a minute, wave, say hi. I'm excited to announce that Greenlight is going to partner with the Tomorrow's Children's Fund on this investment. We're going to donate 50% of the profits earned by the general partner carry on the short sale of Allied Capital to the Tomorrow's Children's Fund.

That's right, just in the carry. Just in the carry, just in the carry. And as you may guess, we're short quite a few shares.

Thank you very much.

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Wrap-up

If you’ve got any thoughts, questions, or feedback, please drop me a line - I would love to chat! You can find me on twitter at @kevg1412 or my email at kevin@12mv2.com.

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