A Hedge Fund Manager's Crusade To Expose Losses

The people who run hedge funds can be famously secretive about their work. Not David Einhorn.

Einhorn founded Greenlight Capital, which manages about $6 billion in assets. He recently waged a very public battle against Lehman Brothers, claiming it was losing more money than it admitted. He turned out to be right.

Now he's written a book, Fooling Some of the People All of the Time, about his six-year battle against another company, Allied Capital. Einhorn says the experience shows how the media and financial regulators can sometimes fail investors.

Each May, hundreds of Wall Streeters show up at the Ira Sohn Investment Research Conference in New York's Lincoln Center. They pay up to $3,200 each for the chance to hear advice from big investors like Carl Icahn and Wilbur Ross. One of the speakers this year was the brainy, boyish, 39-year-old Einhorn, whose hedge fund has racked up some impressive gains over the years. Einhorn began his speech with some unfinished business:

"I want to go outside the usual format for this investment, and for this conference, and ask this audience, by applause, who agrees with me that there should be some significant consequence for the folks at Allied Capital for what they've done?" The crowd applauded and Einhorn continued: "Thanks; there's a lot of people here; there's a lot of media people here. I want them to hear it."

Critical Research

You might say Einhorn is on a kind of crusade. Six years ago, at this very conference, he began talking about accounting problems at a Washington, D.C.-based company called Allied Capital. He's still doing so today, at some personal cost.

"The effects of the pushback have been tremendous, there's no question about it," he says. "It's expensive; it's been not that pleasant; certainly it's a deterrent toward other people standing up and discussing critical research about companies."

Sitting in a dressing room after the speech, Einhorn says he first heard about Allied Capital when he was researching stocks to buy. Allied is a business development firm that makes loans to medium-sized companies. Einhorn came to the conclusion that Allied was misstating the value of the loans it had issued using accounting tricks. Einhorn, who is also a well-regarded poker player, figured that when he laid out his case against Allied in detail, regulators and the media would go after the company.

Former journalist Herb Greenburg, who runs a research firm, believes Einhorn made a strong case against the company. And its stock price fell. But then Einhorn himself came under attack.

"What so many people on Wall Street don't want to even think about is what the risk is, and that's what David was doing — he was pointing out the risk," says Greenburg.

Federal Regulators Take Notice

Allied denied Einhorn's allegations. It noted that Einhorn had shorted the company's stock. That meant he would benefit if its value fell. They said by going public with his charges, he was trying to manipulate the price.

Einhorn replied that yes, he was not exactly a disinterested observer. But neither were the managers defending the company. They owned stock and wanted to see it rise. That argument aside, Einhorn found himself called in for an interview with the Securities and Exchange Commission.

"So the first thing the regulators did, I think, was investigate us for the speech and whether the speech was some effort to manipulate the stock," says Einhorn. What did Einhorn make of the investigation? "It was Kafkaesque. It was backward," he says. "It was investigating the whistle-blower, rather than investigating the claims."

Fallout From Speaking Out

The SEC would not comment about the case now; it never brought any charges against Einhorn. But Einhorn has paid a price in other ways. A columnist for The Wall Street Journal likened him to a mugger. His wife was asked to leave her job. And Einhorn discovered that an agent hired by a company employed by Allied had illegally accessed his phone records.

Allied says it didn't know the agent did this. Allied also says that despite federal investigations and shareholder lawsuits, no third party has ever validated Einhorn's claims. Christopher Davies, an attorney for Allied, says the SEC did cite the company for bookkeeping violations, but they were minor.

"Neither of these findings support Mr. Einhorn's inflammatory allegations that Allied has overstated its investment portfolio," Davies says. "In fact, the SEC did not impose any penalties or financial disgorgement, nor did it require that Allied restate its historic financial results or any valuation of its investments."

Einhorn replies that the SEC has an indifferent record when it comes to pursuing fraud at companies unless they've clearly imploded, like Enron.

"So investors should be aware of this, and they should realize that the only person watching out for them is not these Wall Street analysts and not these corporate managements, but they themselves," Einhorn says. "So they need to have appropriate skepticism as they put their money at risk in the market."

Allied's shares have fallen sharply in recent months. The company's stock closed at $13.06 on Tuesday, down from its 52-week high of $33.35. After six years, Einhorn continues to hold a short position on the stock, betting it will drop further.

But Einhorn's campaign against Allied has had mixed results. He notes that since that first speech six years ago, Allied has issued new stock numerous times. Einhorn has done his best to lay out a strong case against the company. But so far, at least, a lot of investors have been willing to look the other way.

Excerpt: Fooling Some of the People All of the Time

Book cover for Fooling Some of the People All of the Time

Just two weeks after the speech, Allied held a second conference call on May 29, 2002. Walton came out firing. "We understand [our business] better than any external individual, and we are going to continue to communicate our understanding to you," he said. "But let's be clear: We are not having an academic, intellectual debate. The shorts are people with an agenda and a lot of money and reputation riding on trying to get investors to deconstruct our company and to view the Allied Capital glass as half empty."

Allied first tackled the Audit Guide problem. The company conceded that its argument about the Audit Guide changes was false and acknowledged that the Audit Guide, in fact, changed in 1997. Now, Sweeney asserted on her honor that Arthur Andersen had not identified any problems with the audit. Andersen had shut down due to Enron-related liability, and Allied had just hired a new auditor. Though we will never get to the bottom of why Andersen changed the language, we know Allied's first explanation was a lie. In any case, whoever opined that Velocita debt was worth par at the end of 2001 didn't do much of an audit.

Walton continued the call with a valuation discussion. "The other issue is that shorts seem to think that we should write loans down to zero at the slightest sign of trouble, regardless of whether there has been money lost," he said. Obviously, we don't believe that loans should be written to zero at the slightest trouble. Walton is smarter than that. Finally, he repeated what Roll told us, "We write loans down to the amount that we believe we will collect."

Larry Robbins of Glenview Capital pressed the company about the carrying values of troubled credits. Roll explained, "Sure, Grade 3 assets, really we don't see any real risk of principal or interest loss in what we call [loans] in 'monitoring.' In other words, we're working with the company, and it can be a Grade 3 for a variety of reasons. They can be a Grade 3 because they're working on something with their senior lenders, they can be a Grade 3 because we've had companies go into Grade 3 because we're working with them and they're up for sale and, as a result, [they're not paying us] for whatever reason until they sell. But they can be a Grade 3 for a variety of different reasons.

"Grade 4 is where we get a lot more concerned, because Grade 4 we think we've lost contractual interest due to us. In other words, the deal we went into with respect to what they were supposed to pay us in interest, we don't think we're going to get that contractual interest. Now, we don't think principal's impaired, but we do think we have contractual interest loss. Grade 5 is where we think we've not only lost contractual interest, but we've actually lost principal. And this is principal, so it's cost basis. In other words, it's money that went to them that we don't think we're going to collect back. So if an asset is in that situation, [it] is a G0rade 5."

Robbins persisted. "But your carrying values of Grade 4, for example, there is a likelihood that you would not receive guaranteed interest, but you would still receive contractual principal. Where are you carrying those Class 4 loans?"

"It depends on the asset, but most of those would be carried at original cost and . . ." Roll said.

"So, it's only a Class 5 loan that would get written down below cost?" Robbins asked.

"Right," she said.

Here we are back to day one of freshman investing class, where beginning students learn that when an investment reaches a stage where the investor would not repeat the investment, it is no longer worth the original cost. As a result, loans to companies performing below plan, violating covenants, or even not making interest payments-including to the point that Allied realized it would never collect the interest-are not worth cost. Nonetheless, if Allied believed it would eventually recover its principal (Grade 4), it valued the investment at cost. This might be called the "you-have-got-to-be-kidding-me" method of accounting. Walton wanted people to believe that we thought loans needed to be written down to zero at the first sign of trouble. What we believed was that these loans might be worth more than zero, but they certainly were not worth 100 cents on the dollar, as Allied's financial statement indicated.

Sweeney then introduced a white paper (essentially a research paper) that she and Roll authored describing Allied's valuation strategy. "We have a consistent process we've used to determine fair-value, and that process is clearly outlined in our disclosure document," Sweeney said. "In addition, if you visit our Web site, you will see that we have written a white paper on fair-value accounting and our interpretation of its application. We wrote this paper for a conference on BDCs in February. We encourage you to read the white paper to obtain a better understanding of fair-value."

Investors didn't need to read Allied's white paper to learn about fair value. It's not up to Allied; it's up to the SEC. In 1969 and 1970, the agency issued accounting series releases (ASRs) describing how investment companies need to value investments. ASR 118 says, "As a general principle, the current 'fair-value' of an issue of securities being valued by the Board of Directors, would appear to be the amount which the owner would reasonably expect to receive for them upon their current-sale." Then, it elaborates on how to value both marketable and unmarketable securities. ASR 113 indicates it is improper to continue to carry securities at cost if cost no longer represents fair-value as a result of the operations of the issuer, changes in general market conditions, or otherwise. Furthermore, investment companies have to take into account restrictions on selling when determining fair-value.

Excerpted with permission of the publisher John Wiley & Sons, Inc. from Fooling Some of the People All of the Time. Copyright (c) 2008 by David Einhorn.

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