An Allied Autopsy

Includes: AFC, ARCC
by: Patrick Harden

Allied Capital (NYSEARCA:ALD) shares have changed hands for the last time. Ares Capital (NASDAQ:ARCC) acquired Allied for $5.00/share after the 2008-2009 financial crisis brought Allied to the brink of bankruptcy. The merger provides a rather anti-climactic ending to what has been a very passionate battle between die-hard shareholders and the persistent shorts.

Allied, which traces its roots back to 1958, became a bellwether of the business development (BDC) company community when it was created in 1997 from the tax-free merger of five separate companies. Allied was a relatively obscure BDC until hedge fund David Einhorn publicly targeted it in May 2002. Allied, he argued, was using misleading accounting to improperly inflate its asset values. The strength of Einhorn's convictions, particularly in light of the high dividend yield Allied sported, made the stock an instant story.

The stock remained in the spotlight until the financial crisis of 2008 and the bankruptcy of a significant holding (Ciena (NASDAQ:CIEN)) sank Allied's stock permanently into the single digits. After the 2008 audit forced additional asset markdowns, Allied breached the 200% net asset coverage test required of BDCs and triggered a technical default on its debt. However, the stock had already fallen off the mainstream radar amidst the choas and calamity of the Lehman Brothers (OTC:LEHMQ) bankruptcy and the AIG bailout.

Now, as Allied is submerged into Ares and becomes a footnote in stock market history, the question remains - was Allied really nothing more than a financial scheme? Yes and no. Allow me to explain.

1) Was Allied mismarking its investments with respect to GAAP?

Most likely. Einhorn suggests in his book, Fooling Some of the People All of the Time, that Allied exhibited a pattern of delaying writedowns and writeoffs, both smoothing and burying losses with offsetting gains from timely portfolio exits and/or positive revaluations. It's no secret that Allied disagreed with the SEC's view of GAAP application and felt that the FASB did not understand ALD's portfolio and the private equity business in general. While Allied firmly believed that its holdings were "money-good", the accounting guidance was typically at odds with ALD's position. It appears that Allied sought to level the playing field by using the considerable pre-FAS 157 latitude afforded to management by loosely applying fair value rules.

As Einhorn shrewdly notes, because of Allied's numerous equity raises (more on that in a minute), the balance sheet was constantly growing, allowing Allied to cloak writeoffs in immateriality and minimize the impact on NAV. Fortunately, the high distribution yield kept a floor on the stock price, facilitating frequent secondary offerings.

2) Was Allied a Ponzi scheme?

Most emphatically, NO. As a business development company, Allied is required to distribute 90% of its annual investment company taxable income. Because the Company was required to distribute most of its earnings, it had to issue equity to grow the business. From time to time, depending on cash needs, the proceeds of equity issuances might have been used to fund the distributions. This is not a new concept. Non-BDC closed-end funds do this all the time. Because of Allied's portfolio structure and the nature of its investments, Allied generated a lot of non-cash income (PIK dividends, etc.) While the economics of non-cash returns may be debated, the fact remains that Allied did generate income from its business activities. Based on the tax code, Allied has fully covered its dividends from ordinary taxable income and/or capital gains since 2000. From a tax perspective, Allied wasn't even resorting to returns of capital (a practice that happens regularly in the CEF world).

However, it's clear by reviewing Allied's unrealized gains and the character of its distributions that the Company had sold off the majority of its most profitable investments when the music stopped in 2008. Deferred gains from prior year installment sales accounted for over 50% of the 2008 dividends, not current income. Allied was having to sell winners and hold losers to maintain its high yield. Such a practice is not sustainable over a long-term horizon, but Allied managed to produce enough winners to keeping the party going for many years. Whether or not Allied would have run out of juice in 2009 is something we'll never know, but the day of reckoning was certainly drawing closer (until it became a moot point post-FAS 157.)

Business development companies are a misunderstood lot; the accounting is complex and evaluating operating performance requires close and careful analysis. Allied was at least average in its investment decisions; possibly better than that. They were certainly above-average in managing financial reporting and keeping shareholders happy. Ultimately, it's hard to say if Allied had a terminal disease when the cause of death was homicide.

Disclosure: No positions in any stocks mentioned.