July/August 2002, Volume II, Issue 7
George Cole Scott, Editor

Interview with William L. Walton, Chairman and Chief Executive Officer of Allied Capital Corporation

Allied Capital Corp. (NYSE:ALD) is a closed-end management investment company that has elected to be regulated as a business development company (BDC) under the Investment Company Act of 1940. This is how mutual and closed-end funds are regulated. ALD has a subsidiary that is also regulated as a BDC, called Allied Investment Corporation. It is licensed under the Small Business Investment Act of 1958 as a Small Business Investment Company (“SBIC”). In addition, the firm has a real estate investment trust subsidiary, Allied Capital REIT, Inc. and several other subsidiaries.

The total value of the Allied Capital portfolio at the end of 2001 was $2.33 billion of which $1.84 billion were held in loans and debt securities. This compares to a total value of $1.79 billion at the end of the year 2000.

The purpose of the Company is to provide long-term investment capital to support the expansion of growing businesses in a variety of industries and in diverse geographic locations. The lending and investment activity is focused in private finance and commercial real estate finance or the investment in non-investment grade commercial mortgage-backed securities known as CMBS.

The Company’s earnings depend primarily on the level of interest and related portfolio income and net realized and unrealized gains earned on the Company’s investment portfolio. These earnings are after deducting interest paid on borrowed capital and operating expenses. Interest income results from the stated interest rate earned on a loan and the amortization of loan origination points and discounts. The level of interest income is directly related to the balance of the interest-bearing investment portfolio multiplied by the weighted average yield. The Company’s ability to generate interest income is dependent on economic, regulatory and competitive factors that influence new investment activity and the Company’s ability to secure debt and equity capital for investment activities. The headquarters are in Washington, D.C., and the shares, which have been publicly traded since 1960, are listed on the New York Stock Exchange.

Allied Capital has a long record of increased earnings and dividend growth. It holds approximately 130 companies mostly in the form of loans, though it typically structures them to get equity warrants as well. Allied privately negotiates its deals rather than participate in public offerings. Its structure differs from most venture capital companies as it invests in later stage companies. A typical Allied portfolio company has annual sales averaging from about $80M to $150M, is cash flow positive, and on average has been in business for 25 to 45 years.

Portfolio and Investment Activity

	2001 ($ million)	2000 ($ million)	1999 ($ million)
Portfolio at Value	$ 2,329.6	$ 1,788.0	$ 1,228.5
Investments Funded	680.3	901.5	751.9
Change in Accrued or Reinvestment Interest & Dividends	51.6	32.2	12.8
Repayments	74.5	111.0	139.6
Sales	130.0	280.2	198.4
Yield	14.3%	14.1%	13.0%

The Company raises debt and equity capital for continued investment in its portfolio. Because the Company is a Registered Investment Company (RIC), it distributes its income and requires external capital for its growth. Because the Company is a business development company, it is limited in the amount of debt capital it may use to fund its growth, since it is generally required to maintain a ratio of 200% of total assets to total borrowings or approximately a 1:1 debt to equity ratio.

To support its growth during the year ended December 31, 2001, the Company raised $286.9 million in new equity capital through the sale of shares from its shelf registration statement. The Company issues equity from time to time when it has attractive investment opportunities. In addition, during 2001 the Company raised $11.5 million in new equity capital through the issuance of shares in the acquisition of one portfolio investment and through the dividend investment plan. At December 31, 2001, total shareholders equity had increased to $1,352.1 million.

The Company’s Board of Directors reviews the dividend quarterly and may adjust the dividend throughout the year. For the first, second, and third quarter of 2002, the Board declared a dividend of $0.53, $0.55 and $0.56 per common share. Dividends are paid from the Company’s taxable income.

The Company’s dividend policy allows it to continue to distribute some capital gains but will also allow it to retain gains that exceed a normal capital gains distribution level, and, therefore, avoid any unusual spike in dividends in any one year. The dividend policy also enables the Board of Directors to selectively retain gains to support future growth. The Company qualifies to be taxed as a RIC under Subchapter M of the Internal Revenue Code of 1986, as amended if the Company meets source of income, diversification and distribution requirements. It would cease to qualify for such pass-through tax treatment if it were unable to comply with these requirements. It would then be subject to a 4% excise tax and/or corporate level income tax if they failed to make required distributions as a RIC. If the Company ceased to qualify as a RIC, it would become subject to federal income tax, which would substantially reduce its net assets and the amount of income available for distribution to its shareholders.

Allied Capital has a dividend reinvestment plan so shareholders may reinvest their dividends, capital gains distributions, and returns of capital paid by the company.

Valuation of Portfolio Investments

The Company, as a BDC, invests primarily in illiquid securities including the debt and equity of private companies and non-investment grade commercial mortgage-backed securities. The Company’s investments are subject to restrictions on resale and generally have no established trading market. The Company values its securities at fair value as determined in good faith by the Company’s Board of Directors in accordance with the Company’s valuation policy. The Company determines fair value to be the amount for which an investment could be exchanged in an orderly disposition over a reasonable amount of time between willing parties other than in a forced or liquidation sale. The Company’s valuation policy considers the fact that privately negotiated securities increase in value over a long period of time, that the Company does not intend to trade the securities, and that no ready market exists. The Company’s valuation policy is intended to provide a consistent, conservative basis for establishing a fair value of the portfolio.

For more information, please visit the web site at www.alliedcapital.com, call Allied Capital Investor Relations toll-free (888)253-0512 or e-mail the Company at ir@alliedcapitalcapital.com.

Interview with William L. Walton, Chairman and Chief Executive Officer of Allied Capital

William Walter has served on the Board of Directors since 1986 and was named Chairman and CEO in February 1997. Mr. Walton has an extensive background in finance, general management, private equity, strategic planning, mergers and acquisitions, entrepreneurship, private sector educational services, and commercial lending. Mr. Walton received both a B.S. and MBA from Indiana University where he serves on the Kelly School of Business Board of Advisors.

Scott: You have a very descriptive annual report, but I found that you have two descriptions of your fund, which has confused us. In one place you state it is a “Business Development Company” and another you say it is a “closed-end management investment company”. The latter is a new term for us: we know what closed-end funds are and what business development companies are, but a closed-end management investment company is a new term for us. Would you explain this to us as clearly as you can?

Walton: We are technically a “closed-end management investment company” which indicates that we have a Board of Directors, unlike, for instance, a unit investment trust. In addition, we have elected to be regulated as a BDC rather than a closed-end investment company.

Scott: What we are really trying to accomplish now is to educate our investors about BDCs. Because there is confusion understanding the two groups, I have contacted the Closed-End Fund Association, the trade organization for our industry, about inviting more of your members to join our association. So far there are only two members, Renaissance Capital and meVcDraper Fisher Fund.

What we are trying to do is to explain what Allied Capital is in relation to other funds so we can understand it. You must admit that it has a complex structure, which is very different from what our investors are used to seeing. Closed-end fund investors are used to buying a fund at a discount to net asset value and seeing the net asset values published in the financial press weekly and more recently daily. Only Renaissance, the Draper Fisher Fund and Equus II, do this at the present time. Brantley Capital is listed in the Wall Street Journal, but only the market price is given, so they will have the exposure.

A big reason many investors we are attracted to Allied is the large dividend payout. This is especially true because this important in the three-year down market we have experienced. My firm, Closed-End Fund Advisors, since preservation of capital is a prime objective, has been searching for a fund like yours. Our best investments have been in REITs, because of the steady dividend distributions, which increase, year-to-year with the best of them. That is why we are starting to use Allied, particularly for income-oriented investors.

Walton: We are definitely in the mode to produce income for our shareholders. We have been paying dividends since 1963 and have increased or kept regular quarterly dividends, on an annual basis, level every year since then. From the very beginning, we have been structured to dividend is $0.56 per share, and the stock is yielding about 11% currently.

Scott: This is what I am trying to clarify. Your primary income comes make long-tern investments in private companies. Our current quarterly from your loans, not from your equity investments, isn’t that true?

Walton: It is both. We make our investments in the form of long-term debt. We charge a coupon and also receive equity kickers usually in the form of free warrants in addition to the coupon. It really is a beautiful thing: the income stream is a three legged stool where we have interest income from the portfolio, fees from our portfolio companies up front and capital gains when we exit the investment.

Scott: That is also where the confusion comes. When we think of debt, we think of closed-end bond funds, and you are not a bond fund. However, I have been studying your last two annual reports, and I believe I am beginning to understand what you do.

Walton: When you think about it, long-term equity capital is not readily available to middle market companies, which was part of the reason why, in 1980, Congress passed the legislation that created business development companies. This is an under-served niche requiring a significant amount of management and investment expertise to serve the niche. This is an important part of it. The other part is that we are chartered to hold illiquid assets to maturity. Unlike an equity or bond fund that trades, part of the reason our portfolio yields are what they are is that we hold illiquid assets. An overwhelming majority of the time, we only exit an investment when the entire company is sold, either through a strategic sale, a recapitalization or through an initial public offering.

Scott: You are probably familiar with Tri-Continental Corp, the largest of the closed-end funds with assets of about $3 billion. I see you as the Tri-Continental of the BDC world as you are the largest in your group. What are the total assets in BDC’s?  I want to compare that number to the approximate $133 billion in closed-end funds.

Walton: I think the BDC industry has about $5 billion and Allied Capital is the largest BDC by far. There are about 20 BDC’s altogether. I think the important thing to understand is that we really function more like an operating company than an investment fund.

Scott: Yes, you have earnings per share, which differ from the emphasis we place on net asset values.

Walton: We do, but the measure of our success is dividends per share. If you look at our dividends as a percentage of our net worth over the last six years, our shareholders have had a 16% annual return, which could be considered a measure of “cash return on equity.” Most closed-end funds don’t have that kind of return. Our charter is also to provide “significant managerial assistance”.

Scott: I know that from analyzing Renaissance Capital, a BDC based in Dallas. Do you see yourselves as value or growth investors?

Walton: We see ourselves as cash flow investors. We probably tend more towards value than any other category. Occasionally, we look at companies that have high growth. But we have been most successful in finding mature cash-flow companies growing 5% to 15% a year that need capital for expansion, re-capitalization or management buy-outs. Generally, these kinds of companies have been consistent winners, and this is what has worked well for us over the years.

Scott: How do you find them?

Walton: We have an extensive Rolodex of referral sources. Many niche investment banks in the country are in it, plus a significant number of intermediaries. Also, we see deals from private equity funds that provide the equity that supports our debt capital. We probably look at hundreds of deals a year and are highly selective. By one calculation, we see 50 companies for every one we invest in.

Scott: Is there any similarity in what you do to what many closed-end funds do, that is what is called “managed distribution” where they pay out a percentage of their net asset value ranging from 7% to 10% each year? Is that at all analogous to what you do?

Walton: No, our business model is based on taxable income: interest income, fee income and capital gains. We are required to distribute 90% of our ordinary taxable income, but we are not required to pay out capital gains, although historically we have paid gains out.

Scott: You have raised a very important question there. You just said you are not required to pay out capital gains. But you are regulated by the Investment Company Act of 1940, which requires you to pay out 90% of realized gains unless you pay the federal tax for shareholders and pass along the investment tax credit to shareholders as some funds do. Do BDCs have some special dispensation on this tax question?

Walton: No, like any regulated investment company, if a business development company follows the rules and pays out a majority of its ordinary taxable income, it may choose to distribute or retain its realized capital gains. If a BDC chooses to retain the gains, the BDC would generally deem a dividend, which means that the BDC would deem to distribute the gains and would pay the tax and provide a tax credit on behalf of its shareholders.

Scott: This is what closed-end funds also can do. I am on the Board of Directors of a closed-end fund, which has done this for years. We have found that the shareholders have to be educated on the value of the procedure. We like the fact that it raises the cost basis of our shares when we pass along the credit. They also have to know that they can get a refund in tax-deferred accounts such as IRAs.

We just bring this up as, again, we are trying to understand the differences between the two types of funds. Closed-end funds are simple to understand compared to your structure. I know that a BDC gets involved with managements and nurses them along which cannot happen with mutual funds or closed-ends.

Walton: That is exactly right. As I have said, trying to compare us to a typical closed-end fund that is externally managed really has no bearing on BDCs. The internal management of a BDC like Allied Capital is an important element. We have no external investment adviser.

Scott: The internal management is the important thing to focus on. I need to point out that there are some closed-end funds that are internally managed such as Adams Express and General American Investors. Those funds take great pains in pointing out that they are internally managed and that their expense ratios are lower because they are internally managed.  My question is that your expense ratio appears to be extraordinarily high in relation to closed-end funds of a similar size. Why is this?

Walton: George, you have to compare this to the unleveraged yield on our portfolio and our investment returns. You get what you pay for. The expense is far different from running a bond fund portfolio. Do you realize that we have 38 professionals overseeing 130 companies? We can’t create that kind of value another way. You have got to look at our expense ratio not comparing us to closed-end funds but compared to a commercial finance companies whose expense ratios are about 40% of their net investment income and to banks whose expenses are that, or even higher. Our expense ratio is incredibly efficient.

Scott: We are just trying to explain this to our investors who may not understand how these different entities work.

Walton: You have to look at the private equity industry for a better set of comparables such as The Carlisle Group, Kolberg, Kravis & Roberts (KKR) or Tom Lee which are private partnerships that invest in operating companies and help build them up. Ted Forstmann or Tom Hicks run private equity funds and invest in the same asset class we do. KKR is a company that invests in mature companies with lots of cash flow and extremely mature business models and has reasonable growth. They hope to make them grow a little faster.

Scott: You have been talking about an area in which we have little expertise. I am gratified to learn something about your world in comparison to ours. There has been some concern on Wall Street about how you value your portfolio. This has depressed the price of the stock recently. How are you handling that issue?

Walton: Our valuation is being done today the way it has always been done — in adherence with the SEC guidelines. Our Board has the responsibility to provide a fair value estimate of the assets in our portfolio. It is a process we have followed rigorously for years. So, there really is no valuation issue. There are some people who have an interest in seeing the price of the stock go down.

Scott: I am aware of those interested in profiting from selling short, which seems ludicrous for a credible company like yours. I learned much from your recent webcast, but was surprised that just after it four major brokerage firms lowered their buy ratings.

Walton: I mentioned earlier the three components of income in our revenue stream. The firms that follow us tend to value the interest and fee income more highly than the capital gains income. This year we are having the best capital gains year in our history. We are seeing a higher percentage of our earnings from capital gains and that is very good for our shareholders because they pay taxes on those gains at the lower capital gains rates.

Security analysts, however, only focus on how predictable it is so they don’t look it at the same way retail shareholders do. We don’ t agree with the assessment that interest income and fees are a higher quality of earnings. We see all three elements—fees, capital gains, and income as providing a healthy addition to our income stream each year. We have had years when 50% of our dividends were covered by ordinary income. Last year, 99% of our dividends were generated from ordinary income; this year it should be 80% to 85%, and each year the contribution of each element may fluctuate with the pace of investing, the opportunities for capital gains, and the overall market.

The income that goes to our shareholders comes from the interest and fee income from our portfolio and from our capital gains harvest. We have several companies in any one-year that move into the harvest mode and become opportunities for capital gains. We have had a slow harvest in 2001 because of the capital markets, but 2002 has been a great year for capital gains, and we see some very interesting opportunities in the next couple of years. That is very good for shareholders.

Scott: I want to talk about your dividend reinvestment plan. How many reinvest their dividends?

Walton: Not that many participate as part of a plan although we did raise about $6.1 million last year through the dividend reinvestment plan. Most of our investors like to choose the time when they invest the cash and that way they can also avoid having fractional shares.

Scott: I do some consulting for closed-end funds and BDC’s because of my long experience in these matters. My suggestion is that you ask your transfer agent to payout the fractional shares in cash. Most closed-end funds encourage their shareholders to reinvest the dividends in new shares so they can retain the assets.

Walton: The dividends certainly add up, whether you reinvest at the time the dividend is paid or whether the dividends are periodically reinvested through market purchases.  We have generated about an 18% average annual return since 1960. I’ d say a significant portion comes from the dividend. Price action is a smaller part of the story. The big story is cash dividends every year reinvested. Compound interest is a magical thing when the dividend per share keeps growing. That is our business model. What we are all about is just producing as compound return for shareholders and trying to increase those dividends each year. We admit our business model is more complicated and the business development structure is not a familiar one. So there is an education process and with luck you will be part of that process. That is what we are all about.

Note: None of the information contained herein should be construed as an offer to buy or sell securities or as recommendations. Performance results shown should under no circumstances be construed as an indication of future performance. Data, while obtained from sources we believe is reliable, cannot be guaranteed.

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