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Additionally, though OCA was 40–60 partners with the orthodontists, OCA back-loaded expenses by recognizing the orthodontists’ compensation expense on a “cash” basis rather than on an accrual basis. Based on our research, we discovered that OCA front-loaded revenues and back-loaded expenses to compound the impact of dual aggressive accounting practices on reported earnings.

For the second time, we outlined our concerns to the SEC. In March 2001, OCA announced that the SEC required it to change its revenue recognition to record patient revenues on a straight-line basis. The company delayed filing the annual report to restate results with 10 percent lower revenues and 25 percent lower profits than previously believed. Though the stock fell initially, the bulls believed OCA had put its accounting problems behind it. The restated results created easier future comparisons because OCA re-recognized the same revenues that it had improperly front-loaded and reversed in the restatement. By May, the shares recovered almost back to their previous highs. Partially changing the accounting, however, did not improve the overall bad economics of the business. By the following year, the cash flows badly lagged the earnings, and the shares collapsed. This created discontent among its orthodontists, who had bet their businesses on OCA stock. OCA eventually underwent a massive financial restatement and went bankrupt.

When the books closed in 2001, almost everything had worked. The fund returned 31.6 percent, and our assets under management reached $825 million. The bear market deepened, with the S&P 500 falling another 11 percent and the Nasdaq 20 percent.

Then, early in 2002, our two longest-standing and hardest-fought short sales finally paid off. As described above, after three years, Seitel finally imploded under the weight of its own bad business model and aggressive accounting.

Elán was a different story. Elán, an Irish specialty pharmaceutical company, had a small portfolio of branded drugs and a drug delivery technology applicable to a wide number of possible drugs. We sold Elán short in 1999. Elán entered into a series of licensing deals that appeared to be shams. Elán would invest $10 million in XYZ biotech company. XYZ, often a tiny company, would put out a press release trumpeting that Elán’s investment “validated” their technology. XYZ would use most of Elán’s investment to license Elán’s drug delivery technology to use on drugs in XYZ’s pipeline that were years away from commercialization. Elán recognized the license fee as revenue at 100 percent margins. Essentially, the money traveled a circle from Elán’s pocket to XYZ as an investment and back to Elán as a license. The market paid a rich multiple for this.

We also noticed that Elán’s line-by-line revenue and expense reports were usually nowhere near analyst models. And yet, the bottom line was always a penny or two ahead of estimates. A reported shortfall in one place would almost magically be made up in another. Additionally, Elán had a number of off-balance-sheet, special-purpose entities to hold various assets. These vehicles created an unexplained and growing benefit to Elán’s earnings. There were many other financial statement anomalies apparent almost every quarter. Like Conseco, Elán was not interested in clarifying the issues and, for a long time, the bulls didn’t care. In 2001, the SEC delayed approval of Elán’s financials. We thought the truth would come out, but it didn’t. The SEC completed its review, and Elán had to restate earnings—by one penny . . . one lousy penny! With the review behind them, Elán was “home free,” and its shares took off to new highs.

Over the years, I debated Elán with brokerage firm analysts. After discussing the numbers and the various problems with the earnings, they would conclude by asking, “So what? Why would you short Elán? They never miss earnings. They never will miss earnings. If they don’t miss, you are never going to win. How are you ever going to get paid on your short?” Elán was a rig job, but it was not up to the analysts to notice. Perhaps they noticed, but thought Elán should be rewarded for executing it so well.

In January 2002, The Wall Street Journal ran a lengthy story on the front page questioning many of the aspects of Elán’s accounting that we had observed for years. In the post-Enron environment, the reaction was quite different, and the shares cratered. Though most of Elán’s senior managers were accountants, the company began a serious accounting review. When it was over, the accounting fraud was even worse than we suspected. Elán had been selling off its drug portfolio to other manufacturers and booking the proceeds as “product revenue.” This explained some of the gaps in the financial reporting that we never understood. The shares that peaked at $65 upon completion of the SEC “review” in June 2001 were in the low teens in the spring of 2002 on their way to $1 in October of that year.

Fraud can persist for a long time, and investors, analysts, and the SEC miss things. But, sooner or later, the truth wins. If you know you are right, all you need is patience, persistence, and discipline to stay the course.

The year 2002 started nicely. We were up 12.9 percent by the end of April. Just around that time, we completed our research on Allied Capital, an investment that would require all of my patience, persistence and discipline. And more patience.

CHAPTER 5

Dissecting Allied Capital

In early 2002, the managers of a small hedge fund that specializes in financial institutions called to discuss Allied Capital. They came over and walked through their critical analysis, pointing out anomalies with Allied’s portfolio valuations. They wanted our opinion because they knew of our success shorting Sirrom Capital in 1998, a company with the identical business development company (BDC) structure and a similar strategy to Allied. The story was intriguing.

Allied Capital is the second-largest publicly traded BDC in the country (American Capital Strategies is the largest). Allied was founded in 1958 by George C. Williams as a small business investment company (SBIC) to take advantage of the Small Business Investment