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

By Thomas Heath
Monday, May 31, 2010; 12

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."

Delaney, 46, is a Georgetown University law school graduate with a head for numbers. He helped create a health-care industry finance start-up in the 1990s that earned him and his partners tens of millions of dollars each. Delaney took a couple of years off, then in 2000 saw that banks had abandoned the mid-market financing niche.

He jumped in, founding CapitalSource, which is housed in a high-rise building just over the D.C. border in Chevy Chase.

CapitalSource still has big-name funders behind it; shareholders include Chicago-based private-equity firm Madison Dearborn Partners, Seth Klarman's Baupost Group and San Francisco-based Farallon Capital Management. Its clients include the high-end shoe retailer Jimmy Choo and Exclusive Resorts, the vacation company owned by AOL co-founder Steve Case. All told, its asset portfolio as of Dec. 31 was about $20.9 billion, Delaney said. CapitalSource had about 560 employees at end of last year across the United States and in Europe.

Delaney, who owns 8 million shares of CapitalSource worth approximately $35 million, converted the lender into a real estate investment trust in 2006 so it could invest in health-care real estate. The move proved profitable to CapitalSource, but not so a decision to invest in government agency securities, which plunged in value.

Delaney saved his company by turning it into a bank. As the financial collapse picked up steam, Delaney in 2008 engineered the acquisition of Fremont Investment & Loan, an ailing community bank that had $5.6 billion in deposits and 22 branches. The $170 million acquisition bought him deposits, which are much more stable than loans from banks and the bond markets.

The trade-off for CapitalSource: In return for survival and stability, CapitalSource's new business model involves making less-risky loans that have a lower rate of return. CapitalSource also is more heavily regulated now because as a bank holding company, its activities are subject to the eyes of the Federal Deposit Insurance Corp.

CapitalSource was eligible for help from the federal Troubled Assets Relief Program, but declined to accept the aid. Delaney said the company is trying to chart a new course.

"The days of building a finance company that borrows from banks and the bond market, which is what all three of us did, are over," he said. "You either have to make senior loans out of a bank, or make mezzanine loans out of a business that has very little borrowing."

While Walton sold Allied and Delaney reinvented CapitalSource, Wilkus is determined to forge ahead with a private-equity business model that is very similar to the one under which American Capital went public 12 years ago when it was called American Capital Strategies. That model includes controlling big ownership stakes in companies to which it lends. American Capital declined to comment for this story.

Wilkus, 58, may be the most unlikely capitalist of the three. As a young man, he helped found a commune known as East Wind Community in 1973 on 1,045 acres in the southern Missouri Ozarks. East Wind is still known for the various nut butters that it manufactures and sells, a business that began under Wilkus.

Wilkus became disenchanted with commune life, came to Washington and worked at the Calvert Group for several years before founding American Capital as a boutique investment banking firm specializing in employee and management buyouts of companies. The company morphed into a publicly traded private-equity firm after its initial public offering in 1997.

At its peak in 2008, American Capital managed $20 billion in companies and securities, and employed 700 people at its Bethesda headquarters and in offices around the world, the company said. The company now has $13 billion under management and fewer than half that number of employees, it said.

American Capital, which recently sold 13 percent of its stock to Paulson & Co., is seeking approval from its lenders and other debt holders for restructuring $2.4 billion it owes.

The company has said that when the restructuring is complete, it intends to become a hybrid of its former self. The company will still originate mezzanine mid-market loans, which have higher risk than senior loans but can provide a higher return. But American Capital is going to make a big change in the way it plays in private equity: the firm will invest cash from outside sources, such as pension funds, endowments and sovereign wealth funds, to buy ownership stakes in companies instead of investing its own funds raised from its stockholders or borrowed from lenders.

Much like traditional private-equity firms such as the Carlyle Group, American Capital would likely charge a 2 percent fee on the equity it invests and collect 20 percent of profits. The company intends this structure to allow it to continue to be a single source of funds to complete leveraged buyout transactions, something it was when it invested its own funds in both the debt and equity of buyout deals.

"Which means less upside," said Scott Valentin, a senior financial analyst who follows the business development company sector for FBR Capital Markets. "They will likely have more stable income-producing investments. But probably a lower return."

Allied Capital's Walton is philosophical about his experience.

"Capitalism is a tough game," said Walton, who now operates Rappahannock Ventures, which he will use as a platform to get involved in new media and public policy. "I like the creative part of creative destruction," he said, referring to the theories of the famous economic philosopher Joseph Schumpeter. "I'm not sure about the destructive part."

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