Got that? Me neither. PIK interest means that the lender accepts additional securities, growing the balance of the loan, rather than cash, as interest. It may or may not be a good thing, but Allied gave no response to my point that it has to pass the non-cash PIK income on to shareholders even though Allied has not received cash from its underlying investments to distribute.
Walton explained that cash flow, including principal repayments but before new investments, easily covered the distribution. Allied, however, did not generate cash earnings to satisfy its distribution requirements. Using principal repayments to fund the distribution without making new investments would shrink the portfolio, lowering future earnings. Essentially, this would be analogous to burning the furniture to heat one’s home.
Walton further explained that Allied’s purchases of senior debt at a discount without writing down the existing subordinated debt investment reflected fire-sales of assets that did not reflect the credit quality of what Allied bought. He added, “In fact, it was a huge opportunity for us and very good for the shareholders. Now in cases where we’re buying down senior debt of companies where we have a subordinated debt investment, we recapitalize the business and write down the subordinated debt appropriately to reflect the overall value of the business. So it’s not a question of us buying down senior debt at a discount and leaving the sub-debt in place at its previous structure and value. That simply does not happen.”
Though Walton recognized this as inexcusable, all of our research strongly suggests that this simply did happen at three Allied portfolio companies prior to Walton’s remark: ACME Paging, American Physician Services and Cosmetic Manufacturing Resources. Allied eventually had large write-downs on all three. The recapitalizations delayed the write-downs, giving Allied time to outgrow the problems by repeatedly issuing new shares.
Regarding fair-value accounting, Sweeney explained, “I think what people miss when they try to understand fair-value accounting is fair-value accounting takes into consideration the fact that a BDC is holding private illiquid securities held for the long term. It is not meant to take into effect the liquidation or fire-sale accounting.”
There is no such thing as “fire-sale accounting.” A fire-sale means a sale of assets at reduced prices to raise cash quickly. Sweeney invoked the colloquial term “fire-sale” because an SEC administrative law judge used the term in an opinion and indicated that investment companies should not value investments at “fire-sale” prices. I hadn’t said anything about fire-sale accounting.
For BDCs, the SEC requires fair-value accounting, the price at which an informed, arm’s-length buyer and seller would transact. For the next several weeks, Allied repeatedly and disingenuously claimed that we insisted on “fire-sale accounting.” In an effort to discredit our analysis, Sweeney redefined what I said to make it refutable. She knew most listeners hadn’t heard my speech and must have believed they wouldn’t know the difference.
Furthermore, Sweeney’s answer made no sense. The anticipated holding period is not relevant to fair-value accounting. By referring to the long holding period, she may have been referencing “hold-to-maturity” accounting, which permits loans to be held at amortized cost as long as all the holder expects are the payments to be made when due; fair-value accounting does not permit this method. Further, illiquidity is a reason to discount the value.
Walton discussed the troubled investments that had not been written down to fair-value. He started with NETtel, a bankrupt telecommunications company “that’s been written down to basically the realized value of some asset sales, which are imminent.” The truth was that at the time of this statement, NETtel had been in Chapter 7 liquidation for over a year, and its assets had already been sold. Two quarters later, Allied hid NETtel from further disclosure by quietly moving it from “investments” to “other assets” on its balance sheet. The September 30, 2002, SEC Form 10-Q showed that $8.9 million of receivables related to portfolio companies in liquidation were included in “other assets.” Though they did not disclose which investments these were, we were able to reconcile the disclosure to indicate that they included NETtel and two other investments. Five years later, Allied still has not recognized a realized loss on Nettel.
Walton described Velocita as a partnership between AT&T and Cisco Systems. “We’re in the senior debt,” he said. “We took down [the value] aggressively in the first quarter of this year to about $4 million, which is roughly where we think the company is fairly valued. We do understand that Cisco has written down its investment. But Cisco is in the equity, which, of course, is the first thing to go in a troubled telecom situation. We’re in with a fairly sophisticated group of bondholders here, and we think there are some very interesting recovery possibilities.”
Allied wasn’t in the senior debt but the subordinated debt. Cisco held the equity and the senior debt. Cisco wrote both to zero two quarters earlier. As for the interesting recovery possibilities, weeks later on its June 30 balance sheet, Allied recognized its Velocita bonds to be worthless.
“In the case of Startec,” Walton continued, “if you look at the statement of loans and investments, we have a $24 million debtor-in-possession (DIP) facility, which is the first money out, and this is a company
