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The Dealmakers - Terence O'Hara

Insight Buyout Offers Hints At Allied's Changing Strategy

By Terence O'Hara
Monday, February 14, 2005; Page E01

Allied Capital Corp. last month completed one of the biggest buyouts in its history, taking control of the maker of Anacin and Sucrets in a deal Allied officials say is a prime example of where they want to take the old-line Washington business finance company.

Allied bought control of Insight Pharmaceuticals Corp. in early January, investing a total of $155 million in the Blue Bell, Pa.-based consumer products company. Insight became the latest addition to a portfolio of more than a dozen companies whose stock is controlled by Allied.

Chief executive William L. Walton says the strategy of doing more control buyouts is sound, especially from a competitive standpoint. (Michael Williamson -- The Washington Post)

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Tracking Signs Of a Rebound In Telecom (The Washington Post, Dec 20, 2004)

Allied has traditionally been a lender, buying subordinated debt or making direct loans to mid-sized, mature businesses. Allied will usually take a minority equity interest in a company to which it loans money. But Allied's most reliable source of revenue comes not from gains on that equity, but from interest earned on its loans and from fees it charges the borrower.

But in recent years, under chief executive William L. Walton, Allied has been doing more deals in which Allied buys control of a company's equity, in effect becoming the owner of the business as well as the lender. These "control buyouts," in private equity parlance, are taking Allied and its dividend-hungry investor base into relatively new territory for a public company. Several large private-equity shops that do control buyouts, most notably Carlyle Group, also in Washington, are considering taking their partnership public at some point. Part of this strategy entails diversifying their revenue streams to create a steadier source of earnings. To wit, many partnerships that have been big players in leveraged buyouts are also getting more involved in lending.

Allied, a public company since 1960, is taking the reverse tack by stepping on turf -- control buyouts -- traditionally dominated by the private equity funds.

Comparing companies like Carlyle and Allied is not altogether valid, however. Carlyle's main business is pooling money from wealthy individuals and institutions and using it to buy and sell private companies. Allied is what is known as a business development company, which raises money in the public equity markets from investors whose primary motivation is receiving the dividends Allied pays out. Allied then invests its stockholders' money in mid-sized private businesses. Most of Allied's investments have been in the form of interest-generating loans; the interest provides a steady stream of income to pay dividends. By adding more control buyouts to the mix, Allied is betting more of its capital on the prospect of an increase in the value of its customer, not just on its ability to pay interest.

Not that Allied is giving up on a steady stream of income from the companies it buys. The Insight deal is structured as a combination of debt and equity, and like all of Allied's customers, Insight will pay regular management fees to Allied.

In this context, the definition of an Allied "customer" becomes muddied. For instance, is Insight a customer paying for Allied's money and expertise, or is it a subsidiary of Allied? Legally, it is the former. But practically?

This dichotomy can become sticky. Allied's largest single investment is Business Loan Express, a New York-based maker of Small Business Administration-guaranteed loans. Allied controls more than 90 percent of BLX's equity, yet it derives millions in revenue each year in the form of loans to BLX, dividends and management fees. Some investors have criticized Allied for pursuing this kind of business relationship with a company that is both a customer and an equity investment, saying it creates an inherent conflict, particularly because Allied's actual business performance and ability to sell more stock to investors is closely tied to the value it assigns companies in its portfolio, such as Business Loan Express. Allied disclosed in December that the U.S. attorney in Washington is conducting a criminal investigation involving Allied's relationship to BLX, focusing on transactions between the two companies.

Allied officials declined to comment on BLX.

"When you are a debt investor as well as a control investor, there is definitely a perception that the conflict of interest potential is higher," said Matthew Park, who follows business development companies for A.G. Edwards & Sons Inc. "It boils down to management credibility. Many people who criticize Allied and [American Capital Strategies Ltd., a Bethesda business development company that is also increasing its portfolio of control investments] are saying implicitly they don't trust management. At the end of the day I'm convinced that whether you trust them or not is at the heart of the issue." Park added that he trusts Allied's management.

Walton, in a recent interview, said the strategy of doing more control buyouts like BLX and Insight is sound, especially from a competitive standpoint.

"Our platform is well suited to this because our equity capital isn't recycled every five years," he said, referring to private equity funds that typically don't hold onto a company for more than five years. Because of its structure, Allied can hold onto and help build a business over a much longer term than a leveraged buyout fund, he said. "Private equity funds have to flip their investments. We don't."

Any problems with BLX notwithstanding, Allied has had success in recent years pursuing this model. Its 2001 control buyout of Hillman Cos., a maker of key blanks and other hardware items, resulted in a $149 million gain last March when Allied sold the company to Code Hennessy & Simmons LLC. Allied helped finance that sale with a $47.5 million loan, so Hillman is still a customer. Allied just doesn't own it any more.

Control buyouts like that of Hillman highlight another positive for Allied: When it comes time to exit an investment, Allied decides when and how. Allied's biggest problems with its borrowers come when the interests of the owners of the company diverge from Allied's. Last year Allied, after a protracted bankruptcy proceeding, took control of Bethesda's Startec Global Communications Corp. Allied had been Startec's senior lender. Now, as the owner, Allied has been trying to make Startec into a viable long-term business, and if it fails or succeeds, Allied has only itself to blame or congratulate.

John D. Shulman, an Allied managing director who put together the Insight deal, said management teams at companies often have multiple ways to raise money, Allied's being just one. Being able to provide both permanent equity financing as well as debt gives Allied a competitive advantage. "What we offer is permanent capital," he said. Because Allied is both a lender as well as an equity holder in its portfolio companies, "we want our portfolios to have safe capital structure that helps them grow."

Walton acknowledged that the strategy of doing more control buyouts is "still evolving," but it is based on Allied's basic belief that the economy is improving, which should increase the value of the dozens of consumer products, financial service, health care, industrial and business services firms that make up the bulk of Allied's portfolio. Taking greater equity stakes in those companies is a way for Allied to profit from the rising tide.

Terence O'Hara's e-mail address is oharat@washpost.com.

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