Battered by recession, three investment firms took different paths to survival

By Thomas Heath
Monday, May 31, 2010

Starting in 1997, Bill Walton ran a sprawling downtown D.C. investment conglomerate known as Allied Capital that had ownership stakes in dozens of mid-size companies. Those companies collectively employed more than 25,000 people, earned hundreds of millions, and made Allied and Walton big players on the local business scene.

These days, Walton spends his time at his mountainside retreat 60 miles west of Washington, driving a pickup and tending to his three terriers. The business model that gave rise to his success is now in shambles, brought low by the 2008 financial collapse.

"I went long on the U.S. economy," said Walton, 60, fingering the remains of his Reuben sandwich at a rural Virginia cafe. "And it worked great. Until it didn't. We could have survived any recession, but what happened in 2008 was a once-in-100-year event."

Allied Capital and area mid-market lenders -- Bethesda's American Capital and Chevy Chase's CapitalSource, to name two -- rode a wave of easy money to huge success. Their formula: borrow heavily from banks and the bond market at low rates, lend it to businesses at higher rates, and keep the difference.

Allied and American Capital went further, engaging in what one local financier called "mission creep." They bought controlling stakes in the companies they lent to, typically those with $50 million to $750 million in revenue, and tripled and quadrupled profits on those stakes when the companies were sold.

For a while, the basic model worked fabulously, turning Walton, Malon Wilkus of American Capital and John K. Delaney of CapitalSource into established stars in Washington's financial firmament.

But beginning in 2008, the recession wreaked havoc on the business.

The credit crisis meant their source of funding for new loans had suddenly dried up. And many of the loans they already held were in trouble. Some borrowers couldn't meet interest payments because of the slowdown. Others saw the value of their business plummet amid the downturn -- making the equity stakes held by the lenders worth less.

The lenders were caught in a vise, and eventually ran into trouble with their own creditors.

Faced with extinction, Walton, Delaney and Wilkus followed three different survival routes. Allied Capital sold itself to a rival firm. Delaney converted his firm into a bank. And Wilkus is trying to carry on, but plans to use less of American Capital's own money to buy equity stakes.

Walton sold Allied Capital to New York-based Ares Capital in April, creating a scaled-up company with a more diversified base, less risky loans and investment grade debt that makes borrowing less expensive -- although the returns are unlikely to match the private-equity-like margins Walton engineered during Allied's heyday.

"It's back to middle-market debt and subordinated debt investing," said Walton, a former investment adviser to CBS founder William S. Paley who now owns 400,000 shares of Ares. "The model works if you are focused on subordinated debt and senior debt."

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