In his essay entitled ‘Why Capital Structure Matters’, Michael Milken asserts that, “History isn't a sine wave of endlessly repeated patterns; It's more like a helix that brings similar events around in a different orbit”. This assertion replayed in my mind when I was reading a book by David Einhorn of Greenlight Capital, entitled ‘Fooling Some People of The All of The Time: A Long Short Story’. In the book, David expositions the factors that predisposed Allied Capital (NYSE: ALD), a RIC that was trading on the New York Stock Exchange, to financial weakness.
When Greenlight started shorting Allied Capital, the RIC had a market cap of USD 2.6 billion, and it was trading at two times net asset value.
As a RIC, Allied Capital had the following features:
- 1. It paid no taxes.
- 2. It passed all its earnings as dividends to its shareholders.
- 3. It was limited by law to 1x leverage.
Because of feature #2, Allied Capital could not use retained earnings to fuel its growth; it was forced to finance its growth by issuing new equity at higher multiples to book value. When it did that, ALD could then use the capital, leveraged at 1x, to make mezzanine loans to unlisted companies (A high risk investment strategy).
…Pitfalls of the Strategy
In a serious economic downturn, Allied Capital would experience severe delinquencies in its investment portfolio. And, the value of the collateral it put up for loans from its creditors would fall; which would trigger margin calls. Because the entity wouldn’t have retained earnings to serve as a loan-loss buffer (refer to feature #2); Allied Capital would only have two feasible courses of action:
- Sell its portfolio holdings to meet margin calls: Allied Capital made mezzanine loans to unlisted companies by acquiring stakes in tranches of the companies’ collateralized debt securities. These securities are generally illiquid, and thus, hard to sell in depressed markets without incurring severe losses. Therefore, If ALD sold some of these securities at fire sale prices; it would be forced to write down the value of similar portfolio holdings. This would have an adverse impact on the firm’s NAV and the value of its collateral, which would trigger a second wave of margin calls.
- Raise more equity to create a temporary loan-loss buffer: In economic downturns, investors usually flee from the risky stock markets to the safe havens of sovereign bonds. In short, the demand for stocks falls in economic downturns, and this puts downward pressure on the prices of listed equities. New listings generally miss pricing and capitalization targets in downturns. Therefore if ALD tried to raise equity capital during a downturn, it would do so at a very low premium to NAV. Thus, in a cyclical downturn the RIC would generally be unable to raise enough equity to insulate itself from the effects of margin calls, asset write-downs and rising delinquencies.
Hence, it is evident that the structure of Allied Capital predisposed it to collapsing in cyclical downturns.
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The forces that contributed to Allied Capital's downfall resemble the forces that toppled players who were dealing in asset backed credit securities in 2007 and 2008. And, they have eerie similarities to the forces that led downfall of the REITs that burgeoned in the US during the 1970s (You can read about the REIT boom-bust process in ‘The Alchemy of Finance’ by George Soros, Chapter 2).
Simply stated: it appears that great investment opportunities are spawned by similar forces in financial markets. Or as Michael Milken asserted; the history of financial markets is like a helix that brings similar events around in a different orbit. So, it is profitable for one to familiarise oneself with the forces that created alpha for previous generations of investors: they are certain to come into play in the future!
