Free Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue by David Einhorn

model and aggressive accounting.
     
    Elán was a different story. Elán, an Irish specialty pharmaceutical company, had a small portfolio of branded drugs and a drug delivery technology applicable to a wide number of possible drugs. We sold Elán short in 1999. Elán entered into a series of licensing deals that appeared to be shams. Elán would invest $10 million in XYZ biotech company. XYZ, often a tiny company, would put out a press release trumpeting that Elán’s investment “validated” their technology. XYZ would use most of Elán’s investment to license Elán’s drug delivery technology to use on drugs in XYZ’s pipeline that were years away from commercialization. Elán recognized the license fee as revenue at 100 percent margins. Essentially, the money traveled a circle from Elán’s pocket to XYZ as an investment and back to Elán as a license. The market paid a rich multiple for this.
     
    We also noticed that Elán’s line-by-line revenue and expense reports were usually nowhere near analyst models. And yet, the bottom line was always a penny or two ahead of estimates. A reported shortfall in one place would almost magically be made up in another. Additionally, Elán had a number of off-balance-sheet, special-purpose entities to hold various assets. These vehicles created an unexplained and growing benefit to Elán’s earnings. There were many other financial statement anomalies apparent almost every quarter. Like Conseco, Elán was not interested in clarifying the issues and, for a long time, the bulls didn’t care. In 2001, the SEC delayed approval of Elán’s financials. We thought the truth would come out, but it didn’t. The SEC completed its review, and Elán had to restate earnings—by one penny . . . one lousy penny! With the review behind them, Elán was “home free,” and its shares took off to new highs.
     
    Over the years, I debated Elán with brokerage firm analysts. After discussing the numbers and the various problems with the earnings, they would conclude by asking, “So what? Why would you short Elán? They never miss earnings. They never will miss earnings. If they don’t miss, you are never going to win. How are you ever going to get paid on your short?” Elán was a rig job, but it was not up to the analysts to notice. Perhaps they noticed, but thought Elán should be rewarded for executing it so well.
     
    In January 2002, The Wall Street Journal ran a lengthy story on the front page questioning many of the aspects of Elán’s accounting that we had observed for years. In the post-Enron environment, the reaction was quite different, and the shares cratered. Though most of Elán’s senior managers were accountants, the company began a serious accounting review. When it was over, the accounting fraud was even worse than we suspected. Elán had been selling off its drug portfolio to other manufacturers and booking the proceeds as “product revenue.” This explained some of the gaps in the financial reporting that we never understood. The shares that peaked at $65 upon completion of the SEC “review” in June 2001 were in the low teens in the spring of 2002 on their way to $1 in October of that year.
     
    Fraud can persist for a long time, and investors, analysts, and the SEC miss things. But, sooner or later, the truth wins. If you know you are right, all you need is patience, persistence, and discipline to stay the course.
     
    The year 2002 started nicely. We were up 12.9 percent by the end of April. Just around that time, we completed our research on Allied Capital, an investment that would require all of my patience, persistence and discipline. And more patience.
     

CHAPTER 5
     
    Dissecting Allied Capital
     
    In early 2002, the managers of a small hedge fund that specializes in financial institutions called to discuss Allied Capital. They came over and walked through their critical analysis, pointing out anomalies with Allied’s portfolio valuations. They