Description
Senior debt at 35% of par, 20% yield. AFC is issued by Allied Capital, a Ponzi scheme featured in David Einhorn's book "Fooling Some of the People All of the Time". AFC is covered at today's price even if you write Allied's assets down over 80%. Allied has some bad assets, but they're not THAT bad.
THE NOTES
THE COMPANY
Allied Capital (ALD) operates as a Business Development Company under the Investment Company Act of 1940. BDCs must pay out taxable earnings as dividends and (importantly for AFC owners) maintain debt/equity ratios below 1:1. ALD primarily lends to middle market companies ($50-500m) to finance buyouts, recaps, acquisitions and such. They historically lend at 10-15% cash coupon plus some PIK and/or equity kickers. Needless to say, these are not AAA credits. Losses are recognized at management discretion, and are typically kicked down the road for years until the company has grown 10x via accretive capital raises. This turns what could be a troubling writeoff into a mere rounding error.
ALD also made SBA loans via their Business Loan Express (BLX) subsidiary until criminal prosecutions put a crimp in that business. You can follow the entire sordid story in Einhorn's book, complete with photos of abandoned gas stations used as collateral for fraudulent loans. Anyway, the end result is ALD recently put BLX (now called Ciena) into Chapter 11 and wrote a check for 300m+ to make good on their debt guarantees.
As with many BDCs, ALD's Ponzi phase has (temporarily?) ended and they are now in slow liquidation mode. ALD will necessarily apply interest and principal payments toward debt for a while. This is good for debtholders in general, but note that while AFC is parri passu with other Allied debt it is at the back of the line from a maturity standpoint. This is one reason AFC is at 35 cents vs. 75 cents for the 2011/12 maturities.
VALUATION
On 9/30 Allied had 4.6b of assets and 2.2b of liabilities. Their SEC filings list the investments, you're welcome to track down these obscure companies and try to value them. The 80%+ implied writedown I noted earlier is my main source of comfort here. On the cash flow side, Allied's portfolio produced $120m of interest and fees in Q3. After egregious exec comp and other expenses they had about 85m left over to cover 36m of interest. The portfolio also throws off cash via repayments and exits, historically 100-300m per quarter but almost certainly less going forward. Still and all, we're talking about annual cash inflows which exceed 800m which slightly exceeds the implied EV through AFC at current prices.
OTHER ISSUES
Further losses put Allied at risk of violating the 1:1 debt-equity limit. Their remedies, aside from mis-marking assets, are to raise equity or reduce debt. A coercive rights offering is the only way to raise equity right now, and with common at 20% of book value even that is unlikely. A secondary offering below book value is not allowed and preferred offerings are classified as debt and thus do not help (note: some BDCs are petitioning to change treatment of preferreds). Any equity raise would of course be wonderful for AFC. Debt reductions are more of a mixed bag. Allied could get the best bang for their buck repurchasing AFC, either in the open market or via tender, but they'll probably focus on the nearer maturities. Over time this would hollow Allied out, leaving AFC backed by nothing but the bad assets they delayed writing down.
RISKS
1. Secured debt. Allied has none today but could refinance maturing unsecured debt with secured. ALD note maturities are (mm):
2009 - 268
2010 - 408
2011 - 472 (plus revolver, 170 of 632m drawn)
2012 - 339
Any secured borrowing will stretch out the timetable, giving us more years to collect 20%.
2. BLX prosecutions. BLX criminal activity was concentrated in the Detroit branch office. BLX HQ was shocked, shocked to hear of this activity. I'm not aware of Blodgett-esque e-mails leading back to BLX HQ. Allied itself is one layer removed from BLX HQ and is also protected by a corporate veil.
3. Allied could apply for a temporary waiver to the 1:1 debt-equity limit. More problematic they could convert to a C Corp and escape the limit. I don't see how they could fund a C Corp, so it would essentially be a slo-mo liquidation.
SUMMARY
At 36 cents on the dollar and 19% yield AFC offers excellent risk/reward ratio. What makes it better than bonds yielding 20% (or even more) is a combination of AFC's low leverage, as mandated by law, and its position at the front of the capital structure.
Catalyst
1. Easing of credit crunch
2. Allied could buy back some AFC
3. Eventual equity raise