Uncle Sam's Garage Sale: The Allied Capital II Story

Book: Beating the Street by Peter Lynch with John Rothchild | ISBN: 978-0-671-75915-5

When a government has a garage sale, Peter Lynch tries to attend. He doesn’t care if it’s Uncle Sam or the Queen of England. History shows that whenever the government sells something to the public, the buyers usually do well.

The reason is straightforward. In democratic countries, the buyers of government-sold assets are also voters. And governments have enough trouble getting reelected without creating a mass of angry investors who lost money on the telephone company or the gasworks.

The Power of Privatization

Britain learned this lesson early. After two early privatizations (Britoil and Amersham International) came out overpriced and investors lost money, there was widespread backlash. After that, the British government structured every deal so buyers were unlikely to lose, at least in the early going. British Telecom doubled in price in one day. Three million Brits bought shares. No wonder the Tories stayed in office.

Lynch turned this into a principle: whatever the queen is selling, buy it.

At Magellan, Lynch loaded up on British privatizations. British Telecom, British Airways, British water utilities. He loved the water companies especially. They were monopolies. The government had absorbed their debt before selling them. It even gave them a “green dowry,” extra capital to get started. Water bills in England were so low that even if prices doubled, customers wouldn’t stop using water. A portfolio of all five British water utilities doubled in value in three years.

The same pattern played out with telephone companies. Every time a country privatized its phone company, whether in the Philippines, Mexico, or Spain, shareholders made huge gains. Developing countries desperately needed better phone service, so these companies were growing 20 to 30 percent a year. You got the growth rate of a small company, the stability of a blue chip, and the guaranteed success of a monopoly.

Lynch put together what he called the “Queen’s Garage Sale Fund.” If you’d bought every British privatization when it came public, your returns would have been spectacular across the board.

Uncle Sam’s Version: The RTC

But by 1992, there weren’t many exciting new privatizations hitting the market. The old ones Lynch followed, like the Mexican and Spanish telephone companies, had already made their big moves. So he looked for a different way to profit from government selloffs.

He found the Resolution Trust Corporation.

We usually think of the RTC as the agency that sold off condos, golf courses, gold-plated flatware, and corporate jets left behind by the bankrupt S&L owners. But the RTC was also selling loans. Among the mess of bad loans from the S&L portfolios, there were actually good ones. Solid loans to reputable borrowers with real collateral.

The Wall Street banks and investment houses had already scooped up the big multimillion-dollar loans. But the smaller loans, $1 million and under, were harder for the RTC to sell. Nobody was paying attention to them.

That’s where Allied Capital II came in.

Allied Capital: Venture Lending Done Right

Allied Capital was one of the few publicly traded venture capital firms. Its business model was simple. It lent money, mostly to small companies. In return, it got a relatively high interest rate plus a “kicker,” like stock options or warrants, that gave Allied a piece of the profits if the venture succeeded.

The first Allied Capital had an incredible track record. Someone who invested $10,000 when it went public in 1960 was sitting on $1.5 million by the time Lynch was writing. That’s not a typo. $10,000 to $1.5 million.

The secret was discipline. Unlike bankers who threw money around during the S&L boom, Allied’s lenders were extremely picky about who could borrow. They demanded serious collateral. They got their money back.

Now Allied had created a second fund, Allied Capital II, with a $92 million pool. The strategy was straightforward. Borrow against that pool to double it to $184 million. Use that money to buy loans paying around 10 percent interest. If Allied’s own borrowing cost was 8 percent, it could pocket a comfortable 2 percent spread for shareholders, plus the occasional equity kicker from successful ventures. The company had few employees and few expenses.

The RTC Connection

Allied Capital II was using part of its money to buy loans from the Resolution Trust Corporation. These were the smaller loans that the big banks didn’t bother with. Good loans, backed by real collateral, being sold at a discount because the government needed to clean up the S&L mess.

Think about what was happening. The government was liquidating assets from failed S&Ls. It had too much to sell and not enough buyers for the smaller stuff. Allied Capital had the expertise to sort through the pile and find the good loans. It was buying $1 worth of assets for something like 50 cents.

Lynch called the company to make sure the same team that ran the successful first Allied Capital was running Allied Capital II. It was. The shares were selling for $19 with a 6 percent dividend.

Why Lynch Liked This Deal

Lynch saw Allied Capital II as a simple way to turn the S&L disaster into something good. The government had to sell. Allied had the expertise to buy smart. Shareholders got a nice dividend while waiting for the payoff.

It was also a way to recoup some of the taxes everyone was paying to finance the S&L bailout. The government was spending billions cleaning up the mess. Allied Capital II was finding the bargains in that cleanup. If you couldn’t beat the bailout, you could at least invest alongside the people who were profiting from it.

The deal wasn’t complicated. Smart people with a proven track record were buying discounted assets from a motivated seller. It’s the same principle that works at any garage sale. The seller needs to get rid of stuff. The patient buyer who knows what to look for gets a great deal.

Lynch’s broader point about government selloffs is worth remembering. Whether it’s British water companies, Mexican telephone systems, or S&L loan portfolios, when the government is the seller, the price tends to be attractive. Politicians don’t want angry investor-voters. And government agencies selling in bulk don’t have the patience to wait for top dollar.

That combination creates opportunity for anyone paying attention.

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