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Allied in Imbalance: A Story of a Swift Fall

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By Michael S. Rosenwald
Washington Post Staff Writer
Monday, March 2, 2009

This morning, executives from the District buyout firm Allied Capital will huddle in a conference room around a speakerphone, taking questions from tense investors and analysts for the first time since disclosing almost two weeks ago that the firm defaulted on its credit and debt agreements.

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The investment community, nervous for months at how Allied was coping with the recession, was stunned by the disclosure. One analyst told investors that he greeted the news with "disbelief." Allied's stock sank below $1, trading at 60 cents last week after selling for more than $20 a year ago. The company has hired a crisis communications firm.

"This is," said Troy Ward, an analyst at Stifel Nicolaus, "life-or-death time for Allied."

The question on the minds of analysts and investors this morning is how Allied plans to exit a jam that could take down the 51-year-old company, which has investments in hundreds of businesses employing more than 100,000 people around the world. This much is clear: How Allied got here is an illustration of how even small amounts of leverage -- far less than what destroyed Bear Stearns and Lehman Brothers -- can quickly threaten investment companies in a deep downturn.

"In the scheme of things, maybe it's a good thing to point out that any amount of leverage, if it's not managed properly, can certainly be detrimental," said Matt Albrecht, a Standard & Poor's analyst. "Not to say it was poorly managed here, but it's always something to be considered. It hasn't always been at the forefront of people's minds."

In Allied Capital's case, it certainly is at the forefront now.

Allied is essentially a publicly traded private-equity company that uses cash from several sources -- common shareholders, debt issues and credit lines. Allied's focus, like that of companies it competes with, is on making investments in middle-market companies. These firms are too big to be funded by community banks and too small for larger investment banks. Allied has invested in companies as varied as Benefit Mall, an online employee benefits management system, and Huddle House, a chain of Georgia diners that boasts of having served more than 1.3 million hamburgers last year. Nearly 30 percent of Allied's investments are in retail or consumer products.

Allied makes money through dividend and interest payments from its investment portfolio, as well as asset sales. It is classified by regulators as a business development company under the Investment Company Act of 1940, meaning it avoids paying federal taxes by returning most of its profits to investors, usually through hefty and regular dividend payments. But that benefit comes with a hitch: Allied is limited from carrying more debt than it has equity in the business. Not only is that a regulatory requirement, but lenders make the same stipulation.

Here's where Allied has run into problems. Its investments, or assets, are valued quarter to quarter. When the economy weakens, the value of its investments sours. In a turbulent downturn, the souring can happen fast. Companies are hurt by a slowdown in consumer spending, affecting bottom lines. But in a credit crunch, their values suffer further because there is no money in the system for potential acquirers to snap up companies.

Allied declined to comment for this article, citing a quiet period before reporting earnings today. As of Sept. 30, the firm was barely in compliance with the leverage covenants. But the recession deepened in the winter, and things got worse, leaving Allied to announce recently that it was effectively in violation. The company now owes more than its equity is worth -- and even though it isn't leveraged 30 to 1 as Bear Stearns was, it nonetheless finds itself in a squeeze. The lenders and debt holders could demand payment of more than $1 billion. Allied has $215 million in cash.

"Allied does not have alternative liquidity sources to service acceleration of these debts," according to Moody's Investors Service, which has placed the firm's credit under review for a possible downgrade.

Allied's management team, led by chief executive William Walton, is racing to come up with a solution. It is a group, analysts say, that has lost some credibility over the years because of, among other things, nasty confrontations with the noted short-seller David Einhorn. In 2007, Allied admitted that someone hired by the firm had obtained Einhorn's phone records. The company has also been investigated by the Securities and Exchange Commission; two years ago, it settled with regulators who charged that Allied didn't preserve documents to support how it valued investments from 2001 to 2003. Last year, one of its portfolio companies filed for bankruptcy, costing Allied more than $300 million.

"Hopefully they learned from all that," Albrecht said.

Allied's debt holders are holding most of the cards now. They have the right to accelerate payments or pressure the company into a bankruptcy. The latter move is a serious option, but analysts say it is fraught with uncertainty because of the very problem Allied is dealing with -- the declining value of its investments.

"These are small middle-market loans in every industry," said Ward, the Stifel Nicolaus analyst. "It would just be a nightmare to unwind these investments at anything close to a good value. Everyone will know you are a distressed seller." Albrecht, the S&P analyst, agreed: "I don't think it's in the lenders' best interests to take it over or liquidate in this type of environment. It's probably best to negotiate."

Allied is sending signals that negotiating is exactly what's happening. Last month, Allied said it was discussing the debt with its lenders. On Feb. 19, Allied told investors, "These discussions are continuing and, in light of the current market environment, the Company has expanded the discussions to encompass a more comprehensive restructuring of these debt agreements to provide operational flexibility."

The company also indicated that it was working on documents to give its private lenders first-lien security interest on its investment portfolio, meaning that if there were a bankruptcy filing, those debt holders would be first in line, ahead of public debt holders and common shareholders, in liquidating the firm. Analysts say that in return for doing this, the lenders would give Allied forbearance on the covenants and some breathing room under a new package of rules.

"The key, in our opinion, is what will the cushion on the new covenants be and what happens if [Allied] breaks a covenant again?" Ward wrote in a recent note to investors. "We suspect that the lenders will try to keep the covenants on [Allied] very tight in order to better protect themselves. This is where the devil will be in the details. If the covenants remain extremely tight there could be another covenant violation if the financial markets don't improve in the next 6-9 months."


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