A sad farewell to Allied Capital

Washington lost a venerable member of its business community Thursday when a humbled and financially weakened Allied Capital gave itself over to an upstart rival and faded into history.

It was nearly 52 years ago that a group of local businessmen launched Allied Small Business Investment Corp. as a federally chartered lender that pioneered in making "mezzanine" loans to midsize American companies. By standing in line behind secured bank lenders but in front of equity shareholders -- that's the mezzanine -- Allied found it could charge enough interest to pay 6 percent dividends to its legion of loyal small investors, many of whom live in the Washington area. And because its loans often came with "equity kickers" that gave it a small piece of the fast-growing companies it lent to, Allied's shares traded at a healthy premium over book value. And its unbroken success, in both good times and bad, helped spawn a flock of local imitators such as American Capital, MCG Capital, Gladstone Capital and CapitalSource.

In 1997, however, all that began to change. George Williams, Allied's chairman, decided to break with his longtime protege, David Gladstone, and brought in fellow board member William Walton as chief executive. Walton quickly consolidated Allied's five independent divisions, listed the company's shares on the New York Stock Exchange and raised fresh capital through a stock offering and a first-ever bond issue.

Before long, Allied was a major player in commercial real estate lending, securitizing most of its loans. And moving beyond mezzanine lending, it began to compete with its more aggressive and profitable rivals in the private-equity world by taking larger stakes in the companies it lent to. By taking on extra leverage, Allied's balance sheet grew to more than $5 billion by 2007.

As Allied moved into the big time, so did Walton, who became a pillar of the local establishment. He has served as president of the National Symphony, treasurer of Wolf Trap, a trustee of the National Gallery of Art, a member of the Federal City Council, and a director of the American Enterprise Institute and the U.S. Chamber of Commerce. His private clubs include Metropolitan, Burning Tree and Chevy Chase. He traveled the country in Allied's corporate jet and by 2007 was earning just under $11 million in cash and stock, and he had houses in Washington's Kalorama neighborhood and in Little Washington -- Washington, Va.

The first signs of trouble for Walton and Allied came in 2002, when hedge fund manager David Einhorn took a large short position in Allied stock and went public with accusations that the company was overvaluing its investment portfolio and covering up a problem with fraudulent lending at a small-business lending unit. For years, the two sides exchanged charges and countercharges. In the end, a federal judge dismissed a civil suit based on the accounting charges, while a criminal investigation revealed that although there was widespread fraud at the small-business unit, Allied and its management were the victims, not the enablers. The feud was not only costly and damaging to Allied's reputation -- in particular, the revelation that Allied-hired gumshoes had gained illegal access to Einhorn's phone records -- but also revealed serious weaknesses in Allied's management and corporate governance.

Those weaknesses became magnified when financial markets began to unravel. By 2006, Allied had the good sense to see the bubble building in commercial real estate and sold off most of its portfolio at the top of that market. But getting out of its equity investments proved more difficult, particularly after Walton and his team initially balked at selling out at hefty losses. While they delayed, private-equity values crashed, buyers disappeared and Allied's short-term funding began to dry up. By the end of 2009, Allied was forced to acknowledge a $1.6 billion decline in the market value of its investments and loans, putting it in violation of both its federal charter and its loan covenants.

When Allied lenders began calling in their loans, Walton's choices were either to liquidate the company or find a buyer with deeper pockets. The buyer turned out to be Ares Capital, a spinoff of a Los Angeles investment firm that had stuck to the safer business of mid-market lending. By the time the deal closed on Thursday, Ares's all-stock offer was valued at just over $5 for each Allied share. That's a big improvement on the 59 cents Allied shares were trading at back in February 2009 but a mere shadow of the roughly $33 the stock fetched back in 2007. It is also a discount from the net value of Allied's assets on the company's most recent balance sheet.

At Allied's office on Pennsylvania Avenue this week, employees wearing jeans were packing up their belongings. Ares will run the combined company from its offices in New York, keeping only 20 employees here in Washington. And while most top executives are out of a job, they aren't going away empty-handed, thanks to the generous severance payments due under their contracts and a deal struck with Ares to vest their stock options.

Even after giving up more than $3 million of his severance, Walton is set to walk away with $6.5 million in cash and vested options valued at $1.7 million, according to the official proxy. As he sees it, that sum makes sense given how much value he's been able to salvage for Allied's shareholders, who last week overwhelmingly approved the sale to Ares. From another angle, it looks to be a pretty generous gratuity for someone who drove the company into the ditch in the first place.

While we mourn Allied's passing, we can take some comfort that a number of its local competitors survive. Gladstone Capital and MCG Capital managed to move quickly enough to sell off assets and renegotiate new terms with lenders so they can hang on until credit markets thaw. And the always cagey John Delaney transformed CapitalSource into a bank-holding company that now funds its operations with low-cost bank deposits.

Still caught in financing hell is American Capital, which during the boom was so anxious to grab market share, both here and in Europe, that it surpassed Allied in both the size of its balance sheet and its appetite for risk. In the past two years, American Capital has acknowledged realized or paper losses of nearly $4 billion on loans and investments of $10 billion. Chief executive Malon Wilkus has spent months trying to convince his once overeager bankers that they will be better off restructuring their loans than forcing a liquidation or bankruptcy. So far they are unconvinced. Stay tuned.