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 B

few public companies, where we analyzed the SEC filings and checked trading prices to see evidence of aggressive carrying values. To protect its existing investment and delay the day of reckoning, Allied often put more money into apparently troubled situations and/or restructurings without taking proportional markdowns.
     

    According to its own customized scheme, Allied grades its investments on a five-point scale to track the progress of its portfolio:
     
 
Grade 1 is used for those investments from which a capital gain is expected.
     
     
Grade 2 is used for investments performing in accordance with plan.
     
     
Grade 3 is used for investments that require closer monitoring; however, no loss of investment return or principal is expected.
     
     
Grade 4 is used for investments that are in workout and for which some loss of current investment return is expected, but no loss of principal is expected.
     
     
Grade 5 is used for investments that are in workout and for which some loss of principal is expected.
     
     
     
    From James’s database and Allied’s SEC filings, we assembled a list of questions to ask the company. We arranged a call with Suzanne Sparrow and Allison Beane of Allied’s Investor Relations department on April 25, 2002. This would be my first contact with Allied, and in many ways would reflect Allied’s general investor relations practice: Officials answer the easy questions and avoid the hard ones. During this call, and in a follow-up call the next week with Penni Roll, Allied’s CFO, we raised all of our issues and concerns and listened to the company’s responses. The first call, which we recorded in accordance with our standard practice, lasted about two hours.
     
    Early in the conversation, I asked the key question of how Allied determines the value of its investments. “How do you . . . decide what to value the equity for? What do you need, like another financing round to come in that validates the value of the equity or do you do an appraisal? How do you do it?” I asked.
     
    Sparrow described what she called Allied’s Mosaic Theory of valuation, “It is not quantitative definitively. Certainly, there are quantitative factors, but there are also qualitative factors,” she said. “And that’s where some of the BDCs, I think, diverge on methodology with respect to valuation. You see some others who treat it truly as a quantitative exercise.”
     
    “That’s the beautiful thing about a BDC as a vehicle,” she said a moment later. “You don’t have, you know, the bank regulators leaning on you to say you must write-off this asset.”
     
    I asked whether Allied began writing loans down when the risk increased so it would require a higher yield or whether it waited until it realized the investment was a certain loser. She responded that write-downs started “when we believed that we had permanent impairment of the asset.”
     
    This was wrong. As a BDC, Allied has to use “fair-value” accounting, which requires them to value securities based on what they are worth today. An arm’s-length buyer would take into account higher risk and would demand a higher return on a loan that deteriorated. A higher return requirement translates to a lower value. It was aggressive and, in my opinion, improper to wait for an investment to be permanently impaired before writing down the value. My job during these calls was not to argue, but to hear their side of the story. I responded only, “I see.”
     
    Sparrow continued to defend carrying loans that deteriorated at cost. “Grade 3 tends to be carried at cost because nothing has been lost yet; we don’t believe there is permanent impairment there yet,” she said. “So, it’s only when we believe that truly it’s gone and once there is a write-down we take the position that it is permanent. We’re not taking it down because we think it’s going to come back. I mean, obviously we’re going to work real hard to make it come back if