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

wanted our opinion because they knew of our success shorting Sirrom Capital in 1998, a company with the identical business development company (BDC) structure and a similar strategy to Allied. The story was intriguing.
     
    Allied Capital is the second-largest publicly traded BDC in the country (American Capital Strategies is the largest). Allied was founded in 1958 by George C. Williams as a small business investment company (SBIC) to take advantage of the Small Business Investment Act of 1958. Williams had worked for the FBI for much of the 1950s, and since the Small Business Administration (SBA) and all that new funding that was available from the SBA was also right there in Washington, Williams had the good sense to headquarter Allied in the city. The company went public in January 1960, selling 100,000 shares at $11 each. The company began making quarterly distributions to shareholders in 1963. Over the years, several affiliated companies were spun-out or created with similar mandates to make debt and equity investments in small, mostly private businesses that would provide recurring cash flows. Several of these companies would go public, but some remained private partnerships. Williams served as president, chairman, and CEO of Allied and its affiliated companies from 1964 until 1992, when he was named chairman emeritus.
     
    Allied Capital Corporation I, Allied Capital Corporation II, and Allied Capital Lending were closed-end management companies that elected to be regulated as BDCs under the Investment Company Act of 1940. They made private-equity and mezzanine investments in small businesses. Allied Capital Lending made loans through the SBA’s 7(a) loan program. Allied Capital Commercial Corporation was a real estate investment trust (REIT) devoted to investing in small business mortgages sold by the Resolution Trust Corporation and the Federal Deposit Insurance Corporation. Allied Capital Advisers managed the assets of the four other Allied Capital companies. On December 31, 1997, these five publicly traded affiliated companies merged to form Allied Capital Corporation in a tax-free stock-for-stock exchange.
     
    At the time of the 1997 merger, Bill Walton (no relation to the former basketball star) was chairman and CEO of all the merging companies. He assumed the roles from David Gladstone, who resigned as chairman and CEO of the Allied Capital companies in February 1997. Gladstone was a long-time Allied Capital executive, having served as an executive officer of the affiliated Allied Capital companies since 1974. (Gladstone would go on to co-found American Capital Strategies before starting his own publicly traded BDC, Gladstone Capital.) Prior to assuming these positions at the Allied Capital companies, Walton had been a director of Allied Capital Advisers and president of Allied Capital Corporation II.
     
    The rationale for the merger of the separate Allied companies was to simplify Allied’s internal operations and create critical mass to raise the company’s profile with Wall Street and make it attractive to institutional investors. As of December 31, 1997, Allied reported $800 million in total assets, including a $200 million private finance portfolio with investments in eighty-nine portfolio companies.
     
    I asked one of our analysts, James Lin, to replicate our Sirrom work on Allied. He built a large database of all of Allied’s loans showing the cost and value of every investment each quarter for several years. The database showed that Allied’s valuation patterns repeated Sirrom’s. Allied marked down the equity kickers of problem investments, while holding the related loan at cost. This was a good predictor of a future write-down of the loan. Small write-downs disproportionately preceded further write-downs. As in the Sirrom analysis, this indicated that Allied was slow to write-down troubled assets.
     
    The pattern of loan and equity-kicker marks revealed the problem loans. Allied invested in a