The Shorts Strike Back: Allied Once Again Under The Gun –

Two years ago, the publicly held business development companies were beset by interest from the short sellers. At the time, the shorts likened the BDCs to a Ponzi scheme, saying firms were marketing shares above book value in order to fund the dividends that attracted investors. While these claims helped to stifle shares of the asset class at the time, ultimately the shorts were unable to make any of the charges stick.

That however, could change, as Allied Capital was dealt a blow this past December when the firm disclosed it has received letters from the U.S. Attorney for the District of Columbia requesting information as part of a criminal investigation. Allied stock, to the delight of the short sellers, declined more than 10% on the news. Adding weight to this, the disclosure of the criminal investigation follows news from last June that the Securities and Exchange Commission was conducting an informal probe into Allied.

At issue, most are speculating that the inquiries relate to the non-cash transfer of $9 million in loans to Allied from small business lender Business Loan Express, a portfolio company of the firm. The transfer in question is said to have occurred in 2003. Sources have told Buyouts that the loans had come from an existing small business lender in Allied’s portfolio that was merged into BLX in 2000. At the time of the merger, the loans, three in total, were identified as potential problems and purportedly Allied agreed to take them off the BLX books and wrote them down from $9 million to $3 million.

While Allied has not said so explicitly, the firm appears to believe this investigation is the result of pressure from short sellers. The firm said in a press release, “Based on the information requested by the U.S. Attorney, the nature of the inquiry appears to pertain to matters similar to those allegations made by short sellers…” Short positions make up approximately 12% of the total outstanding shares of Allied stock.

Allied Chairman and CEO Bill Walton has traditionally been more overt in impugning the shorts for using any means necessary to undercut the firm’s stock. In a press release issued in June last year, when the SEC undertook its inquiry, he said, “Over the last two years, we have consistently refuted frivolous allegations made by short sellers based upon false and misleading information and distorted facts… As the facts are understood we expect to put this short attack behind us.”

Indeed, to say the firm has battled with the shorts before is to put it lightly, and prior to the December and June disclosures, Allied had appeared to be winning the battle. Merrill Lynch, in a research note to clients, said recently, “In the past, we looked into some of the allegations made by short sellers which on the surface looked quiet damaging, but we were satisfied with the responses that we heard at that time.”

The attacks have reached such a level that Allied has even tried to enlist New York Attorney General Eliot Spitzer to look into it. At the heart of the firm’s claim is that the short sellers use allegations of impropriety as a way to chip away at share price before covering their positions and moving on.

The hedge fund Greenlight Capital, run by David Einhorn, has been accused of this tactic in the past, while others, such as David Rocker, of Rocker Partners, have allegedly used as a sounding board to launch smear campaigns. Another name known by most BDC investors is Jim Brickman, a retired real estate developer who has shorted Allied stock. Brickman gained notoriety with a front-page story that appeared in The Wall Street Journal late last year, and he is credited with uncovering the $9 million loan transfer that is at the center of the unrest.

However, one industry observer notes that Brickman has eaten crow in the past when targeting Allied. “This is the same guy that argued Allied’s Hillman investment should be marked down, and the very next morning after he said that, Allied announced the sale of Hillman for $10 million more than they had last valued it a couple months earlier… It can be very dangerous for anybody on the outside to make stabs at what the value of a portfolio company should be valued.”

Allied Capital sold Hillman Companies in a $510 million deal to Code Hennessy & Simmons in February 2004, and realized a return of $149 million on the investment. Prior to the sale, Allied had last valued the business on Dec. 31, 2003, at $500 million, according to a company press release.

The source tells Buyouts, “With the BDC structure, it’s easy to create a diversion. The whole balance sheet is estimated, so it’s relatively easy to create confusion and that’s what some of these shorts are doing,”

If anything positive can come from this for Allied, the increased attention-if the regulators come up empty-handed-could give credibility to the firm’s assertion that the shorts are unfairly targeting BDCs. There has been some movement that suggests the short sellers could eventually find themselves under the microscope.

SEC Chairman William Donaldson has pledged before to consider amendments to the existing short-sale regulations. In a testimony before the Senate Committee on Banking, Housing and Urban Affairs in 2003, Donaldson outlined plans to curb the potential for stock market manipulation by the hedge funds. He said, “There have been complaints by some issuers that hedge funds have acquired large short positions… then attempted to drive the share price down through the issuance of highly critical and allegedly inaccurate reports on their finances.”

Also, a spokesman for Allied has indicated that Spitzer’s look into the alleged short-seller malfeasance is still pending, albeit at an informal level.