Monday, June 9, 2014

Book review: "Fooling Some of the People All of the Time" by David Einhorn

Fooling Some of the People All of the Time is David Einhorn's account of his years-long campaign against Allied Capital. In May 2002, Einhorn publicly recommended Allied as a short-sale candidate, arguing that the company wasn't taking necessary write-downs on its loan book. Later on, he discovered widespread fraud at one of Allied's subsidiaries. For years after his 2002 speech, Einhorn tried to get regulators to crack down on Allied, with almost no success.

In the introduction to Fooling, Einhorn describes the book as a cautionary tale about a fraudulent company and ineffectual regulators. Reading between the lines, it's also a cautionary tale about Einhorn's stubbornness in sticking with a losing investment. Although his criticisms of Allied were largely valid, Einhorn lost money on Allied for years, and even after the company collapsed in 2008 his annualized return from shorting the stock was quite low.


Background

Allied Capital is a business development company (BDC). BDCs invest in small and mid-sized companies, and for tax purposes they are pass-through entities, which mean they don't pay any taxes themselves-- instead, BDCs distribute their income and capital gains to shareholders, and the shareholders pay the taxes.

In the late 1990s, Einhorn successfully shorted a BDC called Sirrom. He calculated that 40% of Sirrom's loans ultimately defaulted. There was a lag between when a loan was issued and when it went bad, however, and in the meantime Sirrom was constantly raising new capital, which made the losses look artificially small as a percentage of its assets.

Sirrom was a "legal Ponzi"-- it needed to grow constantly, much like a Ponzi scheme needs to grow constantly, to mask the terrible quailty of its loans. In 1998, ripple effects from the crisis at Long Term Capital Management made it difficult for a wide range of companies, including BDCs, to raise money. Sirrom could no longer keep the Ponzi dynamic going, and its stock price collapsed.


From bad to worse

When Einhorn first learned about Allied several years later, he thought it was very similar to Sirrom. Allied, too, had elements of a legal Ponzi-- it was constantly raising money to expand its loan book and seemed to delay recognizing losses. In Allied's case, the Ponzi dynamic was even more acute because it didn't produce enough cash to fund its distribution to shareholders. It had to fund its distributions in part by issuing new stock.

As Einhorn continued researching the company, he found evidence that employees at a large Allied subsidiary, Business Loan Express (BLX), were defrauding the government. BLX was a small-business lender that received loan guarantees from the Small Business Administration, and Fooling documents numerous instances of loan fraud that Einhorn and his associates discovered. BLX also delayed recognizing loan losses and didn't produce enough cash to cover the dividends it distributed to Allied, which required Allied to constantly "invest" more capital in BLX, making it something of a microcosm of its parent company.

Einhorn presented clear evidence of Allied's and BLX's fraudulent actions to various regulators over several years, and they consistently dragged their feet in investigating the companies.
 


Evolving hypotheses

Early in the book, Einhorn describes a lessons he learned while working for a hedge fund called Siegler, Collery and Company. He writes:

"Another difference from SC is that we avoid 'evolving hypotheses.' If our investment rationale proves false, we exit the position rather than create a new justification to hold."

Unfortunately, he didn't take this lesson to heart while fighting Allied.

Originally, Einhorn found instances in which Allied contravened SEC regulations by overvaluing bad loans. He thought that publicizing this would cause investors to sell the Allied's stock and regulators to crack down on the company.

He soon realized that Allied's stockholders were clueless mutual funds and yield hogs who only cared about the distribution, not the fundamentals, and that regulators couldn't be bothered to do their jobs, but he stayed short thinking that rising loan losses would force Allied to cut the distribution.

Then Allied sold a large subsidiary, Hillman, for much more than people thought it was worth, snuffing the argument that losses would lead to a distribution cut, but Einhorn again stayed short. This time he was convinced, despite his past experience with regulators, that fraud would force the government to shut BLX down.

Allied collapsed after Fooling was published: the 2008 recession led to an upswelling of bad loans and killed Allied's ability to raise capital. As with Sirrom, it was a financial crisis rather than endogenous problems that ended Allied's Ponzi growth. My sense is that Einhorn was lucky to have shorted Sirrom right before the LTCM crisis hit it, and this luck made him overconfident about how soon Allied would blow up.


Einhorn's returns

The first few chapters of Fooling describe Einhorn's early career, before his Allied crusade. When he started his hedge fund, he found it almost impossible to raise money and had initial capital of only $900,000. Off that low base, he achieved ~60% annualized returns during his first two years using the strategies profiled in Joel Greenblatt's You Can Be a Stock Market Genius, and this enabled him to raise a lot more money. Once his fund surpassed $100mm of assets, annualized returns dropped to 20%, and once it passed $1bn they dropped to 12-13%. Einhorn's dollar-weighted returns are a lot lower than his unweighted returns, although they're still good.

A lot of Einhorn's success as a hedge-fund manager comes from his being promotional without seeming promotional: he comes across as honest and straightforward, competes successfully in poker tournaments, and has made a few great high-profile calls. He's also been lucky: any fund that starts with less than a million is likely to fold unless it does really well right away.

That's not to denigrate Einhorn's skill, because I think he's better than the vast majority of hedge-fund managers, but even great investors sometimes make flawed investments. Fooling Some of the People All of the Time is proof of that.

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