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- [00:00]
A
Foreign this is Current Yield, Grant's Interest rate Observer of the Air. And I am Jim Grant, and with me, as always, is the great deputy editor of Grant's, Evan Lorenz. He's sitting here to my right, and there's Harrison Wadilbrick down the table. Evan, a lot of what we do is rather improvisational here.
- [00:24]
B
We're just taking a cue from the Federal Reserve.
- [00:28]
A
And today we'll be talking to Dan Zwern, who was the chief executive officer of rina, and then we'll be talking about Arena Investors at length in just a moment. But Evan, I heard something astounding before we got on the air this morning, and that is that J.P. morgan and company is going to accept the collateral of ether and Bitcoin as good collateral for loans. I'm not sure about the terms, whether you have to have have like 300% of ether and 1,000% of bitcoin. That might make sense. But is it a sign in the credit cycle, you suppose, or is it just one of those darn things that keeps on happening?
- [01:10]
B
It's a sign of something. I mean, I remember Jamie Dimon, the CEO of JP Morgan, calling like bitcoin trash just a couple years ago, but now it's trash you can borrow against assuming an appropriate LTV.
- [01:20]
A
Yeah, well, markets do fluctuate, said Jamie's predecessor at JPMorgan. What was his name? J.P. morgan. Right. Yeah.
- [01:28]
B
Also, markets make opinions.
- [01:30]
A
Yeah, I'm not sure that was Mr. Morgan himself. Certainly those are wise words. Now, turning to my, turning to my left here is Daniel's work and Dan is a co founder of Arena Investors. That happened in 2015 with a mandate unconstrained by industry, product or geography that then went what public figure in America would merit the appellation of unconstrained? Is there a high figure in our public life? Who might that be?
- [02:05]
C
Well, first of all, thanks for having me, Jim. Appreciate being here.
- [02:11]
A
I know that your compliance people are just looking over even though they're not here. They're just looking over your shoulder, aren't they?
- [02:16]
C
They might be. I'm not sure if anyone has the ability at in within government to be completely unconstrained, but certainly it's certainly, you know, perhaps we haven't seen this little restraint since maybe Andrew Jackson.
- [02:31]
A
Well, we'll get around to Old Hickory in a moment. I didn't finish with your introduction for the benefit of the listeners who have not been paying attention to Grant's Interest Rate Observer. Who might they be, Evan? Oh, never mind. There's A few of them, right?
- [02:44]
B
A few, yeah.
- [02:45]
A
Dan is the most formidable character. We spoke at our distressed investing event in the spring of 2024. Was it?
- [02:51]
C
It was.
- [02:54]
A
And he held forth in most interesting fashion on the credit cycle broadly and that his, his comments were informed by a career that has carried him into some of the following categories and subcategories of credit, also known as debt, specialty finance, enterprise consumer finance, lending, asset based lending, equipment leasing. Dan is a senior trustee of the Brookings Institution and he is a very familiar presence at the University of Pennsylvania. There he earned BS in economics, that's kind of so to speak, as it were. And a bachelor in applied science and computer science from the University of of Pennsylvania Moore School. The electrical engineer. Now that sounds rather more formidable, although the entire package is distinctly impressive. And finally, an MBA from Harvard Business School. So that was your backup for Wharton, right?
- [03:58]
C
I just wanted to pick up a few things I missed at Wharton.
- [04:01]
A
Okay, so there is Dan's words. And Dan, before we proceed, I want to read you a couple of things. And not to, not to oppress you with comments that you had made a year ago or a year and a half ago, but they struck me at the time as so relevant and so well put and so contemporary then and now. I want to read a couple of them back to you and ask you if your views have changed and if so, why might that be so? You remarked, observed that investors, even the professional kind, seemingly are in the business of leverage masking and nomenclature obscurity. Quote. This is you in the real estate business. You have a core asset in multifamily apartment lending, holding, building. It makes you feel good because it's core and it's stable and it's calm. Except that you're in deeply levered equity at a 5% cap rate and at an 8% cap rate you have a zero. And you talked about speculative grade credit and you said speculative grade private credit couldn't exist without three allied lines of business, collateralized loan obligations, middle market private equity and leveraged finance more broadly defined. And without one of them, you can't have all of them. They are in effect just one business. So the question I have for you to begin with, is this just one business of leveraged finance? Is it okay or is it not okay?
- [05:41]
C
Well, I think there's a lot of fog of war, so to speak, in that every single thing we do, and I think every single thing within the investment business, to the extent that you're trying to optimize returns, you have to recognize is Only episodically of interest, right? Everything cycles. So each permutation of industry, product and geography, whether I'm buying or lending to real estate, or involved in corporate finance or doing specialty finance of all kinds, doesn't matter what it is, it cycles. Why does it cycle? Because that's coherent with the way the human mammal is wired, right? The human mammal sees opportunity, many more of them come, the opportunity is squandered, it's overdone, it blows up, everybody decides it's terrible and no one to touch it. And then a few of those human mammals come up and start doing it again and off we go. And so what we've seen post the GFC, post the great financial crisis of 2008, is along with that, some obscuring of that cycle, right? Because that the cyclical nature of alternatives and investments generally doesn't really cohere with I want to sell investment product every day, right? And I want to say that that investment product is wonderful every day. And so what has happened? Well, the latency between the diminution of value and by the way, it's never when it appreciates, but when it diminishes and when it actually is known to stakeholders involved or invested in value, that value has never been longer. And the innovation that has been employed post the GFC to basically obfuscate the realization of value diminution has been really broad and multifaceted. And so as an example, the only example you had in the alternative space between 08 and late 21 was in the energy PE space. So as an example there, that was a very popular area within private equity. You'll notice not many people, not nearly as many people did it do it now as they did then. And of course they were talking about their great skills in each of the basins. As an example in the United States that they were able to handle oil and gas prices turned out not to be the case. Turned out it was over levered. There was a lot of reasons that it got over levered both from the equity and the debt markets, it blew up. But no one knew it until like 2019, 2020 in the private asset space, the marks didn't seem to go down. And then three or four years later, when you got to 1920 from 2016, lo and behold, a number of those operators became born again renewables players and they forgot they liked carbon and, or usually and not usually or they started buying their own portfolio companies at big discounts right out from under their LPs. Fast forward. We had a really unique thing Right. Which is that we had incredibly irresponsible monetary policy, really starting from the day Draghi decided to tell everybody rates would never go up. Right in 2013. And it was met with outrageously irresponsible fiscal policy, really throughout the G20 and late 21. In response to Covid, that was the excuse. And when you put those two together, you basically have going to create a combination of elevated rates and inflation out as far as the eye can see. And at that point, unfortunately, because of the suppressed rates, there had been a gigantic asset bubble. And as everybody with a calculator and an Excel spreadsheet knows, if you have a higher discount rate, you have lower asset value. Well, it turns out we suppressed the discount rate from 2013 to 2021. We therefore blew up asset values to screaming heights, both in absolute relative value. And then we popped it as basically rates kind of ballooned up right in combination with inflation. However, it didn't seem like it wasn't like 08. It wasn't like there was this big crash. It wasn't even like when WorldCop happened or World Trade center or August 98 or what we saw in 94. It just kind of started leaking very slowly, right? And roughly in the order in which people needed to had no choice but to do so. So it started in tech because it was obvious, but then it leaked over to private equity and other alternative fund interests. The LP units themselves as LPs realized they couldn't get money out of the stuff and they started selling. And then in 23 SVB happened and First Republic happened and people started to realize real estate was loaded with this issue. By the end of 23, more bankruptcies had happened in 23 than since 2010. And it's only escalated. But funny enough, the actual filings, not so much the actual defaults high, but not so much. Why? Because people decided to forget that the default happened or to forget that the bankruptcy was needed and started doing what was what are now called liability management exercises. And then furthermore, touching your toes for money. Yeah, pretty much. And then finally in structured finance and structured credit, it turns out that if you're a special kind of investor like a bank or sometimes an insurance company, you don't have to recognize reality. You can say that I'm going to hold it till maturity and I'm going to decide that this will never go down, even though the market's telling you it is going down. Right. And so basically people didn't have to recognize, as an example, bank of America over $100 billion of losses. And so that phenomenon is happening, but it's almost like slow motion photography from one day to the next. You kind of can't feel it. But if you wake up a year from now, two years from now, three years from now, and you see those increments of time, you can see it happening and it will continue to happen for the next minimum 10 to 20 years.
- [11:31]
B
On the subject of losses that have been incurred but not yet recognized, one thing that surprised a lot of folks in the recent First Brands bankruptcy is just how much debt the borrower had taken off before actually formally filing bankruptcy. And the way that they hit it was they did a lot of trade finance, receivable, credit facilities. And when you do these facilities, you constructed them as a true sale, so they don't actually show up on your balance sheet, but you still are in hock for that money. To what extent are there a lot of other companies who have incurred losses but not yet recognized through these kind of private credit facilities? And are there other ways of doing it besides just trade financing? Like how wide is the problem and how are they doing it?
- [12:09]
C
Sure. Well, we're doing something like that now for somebody where we are the de facto trade financier.
- [12:17]
B
Right.
- [12:17]
C
And so as an example, a middle market direct lender lent to somebody at three to four times cash flow seemed like a reasonable loan at the time. Cash flow was cut in half, not so good. And so the company effectively was not going to be able to service its interest and was going to have to, you know, potentially fold or restructure or go and, you know, go into a bankruptcy. And so they said, well, if you have some hard assets lying around, even though I have a lien on them, you can get some money from somebody else using those assets as collateral, and I'll allow it. And so they went to an affiliate of ours and said, well, now we have these receivables that are money good from great counterparties. And my current lender seems to is going to allow us to effectively scoop these assets out from under them because perhaps they don't want to necessarily recognize the loss or who knows, we don't know where they're marked, of course. And we said, fine, no problem. Right. And so they had a 10 or 11% loan, but they were happy to actually scoop the hard assets out and pay us 16 or 17 to hypothecate these very easy to understand assets and they can let the dream continue.
- [13:24]
A
So JP Morgan also said that he wouldn't lend against all the gold bricks in the city of New York to someone who didn't trust. So why would you undertake that transaction with people who are pretty plainly doing something underhanded?
- [13:44]
C
Well, as you know, JP Morgan used to say, you know, first class business, you know, first class way. Right. At the. On the other hand, I had a very wise mentor who said, if I didn't have X's to do business with, I'd have nobody to do business with. And so the reality is that assets are, are what they are. And the. Now, does that mean, you know, anybody should qualify to be lent to? No. If you did the background work on First Brands and saw their prior relationships with creditors, it wasn't good. I think it's more, are you doing it with open eyes? Right. And so as an example, in real estate lending, there's a brand of lending called hard money lending, which basically means a real estate operator from the boroughs that's fast and loose, who's not the president, but loves to borrow, but needs to do it really quickly. He's got a wonderful building, it's worth a dollar. He said, look, I need it next week, so I'll pay you a premium. All right, well, and I need 50 cents on the dollar, but I'll pay you 17. Right. If you do it within two weeks. Well, we both know what we're getting into, right? We know the building is the building. We know we have to contract in certain ways to be highly, highly protected. We're evaluating the jurisdiction. Right. That we're in and whether we're going to be able to access our collateral. And in those instances, I think, you know, we might be, with open eyes, willing to do that. That's not to say, you know, there's a difference between, as another mentor of mine used to refer to it as criminal with a capital versus lowercase c. And so we're going to look at that person's history and even though we're not going to have a problem with the collateral, boy, if he's really going to run us around too hard to go get our money back, we might not say it's worth it or we might price it in. So I wouldn't use blanket rules in that regard. But in that case, at that scale, with that level of complexity where you don't have hard assets in most of that business and you're talking about a couple dozen acquisition spree with lots of the complexity associated with integration. That's more of an example of what Buffett and Munger, we used to say, which was, I want somebody who works all Day and is super smart and ethical. And if he doesn't have the third one, the first two will kill you. And that's what happened, I think at first prints.
- [16:16]
B
At the start, you described all of leveraged finance as kind of one thing, whether it's private credit, leveraged loans, clos. However, the credit metrics from each one are being reported very differently. There's much higher default rates and kind of leveraged loans than is being reported by private credit. Part of this is because the rating agencies, when there's a distressed exchange like a liquidity management exchange, they will report that as a default. Whereas private credit, if they change the loan terms, they can classify it however they want to. But in aggregate, private credit is kind of lended towards smaller companies than bank syndicated loans. And the companies that are typically rated like single B or lower because leverage loans are often packaged in Clos, and Clos can't buy a lot of single B or lower credits. Are there a lot of hidden problems in private credit? And if so, like, how do you expect them to play out?
- [16:58]
C
Well, there's a bunch of items in what you just said. I would say first of all, leverage finance and direct lending have really intersected, right? Because the number of and size of some of the largest direct lenders means they can effectively compete with the leveraged lending market. And what you see in large scale private equity transactions is that the two are played off against each other. Right. So they've effectively become a lowest common denominator situation. And so the notion that quote unquote, private credit is somehow less or different than leverage loans is really not real. Right now there's some differences because leverage loans can't downscale, Right. So direct loans will go for, you know, you could have a billion dollar or $2 billion direct loan and you could have a 50 or 30 or 20 or $10 million direct loan. It doesn't really leverage loans kind of stop at 3 to 500 million, let's say. And so there's maybe a small delta there, but not a lot. And in most cases, those are incredibly competed for. They come, as they say, covenant Light. Right. There's not a lot of controls, so you have to really look at it as almost senior equity. Right. And so you know that that can be dangerous with regard to what close will buy. They will, they will buy lots of.
- [18:11]
B
Single B. I meant single B or below, because they usually have like, I think it's like a 5% bucket for a below single B.
- [18:17]
C
Yes, yes. Well, below as a whole is a different thing, but it's pretty hard not to get a single B. Right. And really the at some point the limitation there just becomes the cost of the rating. Right. So rating might cost, a shadow rating might cost you 30 to 40 grand. Right. So down to 10 million doesn't work as much. Maybe 30 million it would. Right. Et cetera, et cetera. But again, to say that I'm going to have that much more comfort in direct versus leverage led. It's not really a thing.
- [18:46]
B
Incurred but not recognized is actually an insurance term. Incurred but not recognized is actually an insurance term.
- [18:52]
C
Yes.
- [18:52]
B
And one thing we've noticed is over the last 15 years, private equity, in order to fund its portfolio companies, has gone off and started acquiring insurance companies. In fact, I think arena has actually bought one as well. Some of these private equity owned insurance companies now have large holdings and affiliated paper that is, you know, buy out debt. And they've also reduced their surplus, the capital they hold against their liabilities pretty substantially. Because you're so concerned about kind of the state of leveraged loans and kind of leveraged finance in general, are you also concerned about the insurers who are holding a lot of this paper and kind of the annuitants who rely on these insurers to actually pay out their monthly, you know, income?
- [19:32]
C
Well, there's even more in what you just asked than what you asked previously. There's a lot of different subcomponents there. Right.
- [19:38]
A
So Dan, before you embark on your answer, I want to tell the listeners a little bit about a bittersweet occasion for us at Grants. This is the final episode of Grants Current Yield. We've been doing it for a couple of years. We're trying something new. We're introducing the Jim and Evan show. We've already done one. And the second one will be airing on Wednesday, November 12th at 4 o' clock in the afternoon. That's Wednesday, November 12th at 4pm now this entails a live one hour conversation featuring myself, Evan and our guest, who in this case is Christopher C. Davis, the chairman of Davis Advisors. He's a wonderful investor and a good friend and a witty and observant figure in the financial markets and got a lot to say. And you know, to give you an example of his gravitas, he Christopher Davis is on the board of directors of the Coca Cola Company. That's no small thing. So listen in. Ask questions virtually via a moderated Q and A. So this is live, it is interactive. Ask us stuff. Ask Christopher and register now. So the registration instructions are as follows www.grantspub. that's grantspub.com events. Hope to see you on Wednesday November 12th at 4 o'. Clock.
- [21:08]
C
So let's break it down. So private equity buying life insurers or life and fixed annuity players to fund their companies. That's not really the case. What had happened in most instances was that there were combinations of private equity management companies. The I. E. The GP that manages private equity funds may purchase a life and fixed annuity player using its management company, not its funds capital. Right. As distinct from in kind of, you know, several years ago where they might be financial institution oriented and simply buy the insurance company as a good private equity investment. Right. So those are two different things. And so the question is, well, why did they as a, as a management company by the life and fixed annuity player. Right. Why does that make sense? So it makes sense from the perspective of an alternative investment manager because there are effectively permanent or near permanent liabilities that need to be invested and there's an opportunity to derive to create real value for the insurer by investing well. Right. What does investing well mean? I mean subject to the risk based charge requirements of the insurer to make a return in excess of the cost of origination of the liabilities, the cost of those liabilities themselves and any operating expenses. And that can be a great business if you know how to invest across a lot of different asset classes. Good for the insurers, good for the insurer, good for the policyholders, good for the company. As an asset manager, why do you want to do that? Well, as the maturation of the alternative space has occurred, if you are really any less than 10 billion, you're not even going to get a hearing among the various many gatekeepers that sit between large scale institutions and alternative investment managers. We've gotten to that point. And so if you're seeking to go from non scale to scale, I'm not sure there's a way other than by having access to direct liabilities within the fixed annuity space to do so. So it can make sense for everybody right now. Is that a good thing or a bad thing to have these folks touching policyholders money? I would argue to you that generically it is a good thing. Why? Well, because when you evaluate credit and you think about the focus of the agencies, the insurance regulators and others, as a general matter, there are a ton of type 1 and type 2 errors that are made by those kind of evaluators of credit. Type 1 is they say here's a thing you're doing and it doesn't make sense. Right. Well, there's a lot of situations where you're actually taking very little credit risk and you're getting paid well. And they say that doesn't make sense. I've never seen that before. That's not good. Not good for policyholders, not good for the insurance company. Bad type 2 errors. They say something like, you're not doing something that you should do. So as an example, someone showed us something recently. It was a double A. So what can go wrong? Well, but it was a very subordinated piece of paper where the coverage ratio was created to access a rating that wasn't intrinsically deserved. Right. Why do these type 1 and type 2 errors happen very generically? Because the evaluators of credit think of basically defaults and coverage. Right? Defaults and interest coverage. They say, if the thing hasn't defaulted and the cash flow covers its interest, I feel good. Right. They don't say what's the intrinsic return per unit of risk that's occurring with this security? So that that fact distorts things. And what you should be focusing on is the leverage of an instrument within the capital structure. Right. And the degree to which you're going to lose money if in fact there is a default. Because if I can manufacture low defaults and high coverage by basically having no covenants and charging very little. Right. In the absence of whatever the standard of the credit is. So by introducing people who are a little more focused on intrinsic return period of risk into the insurance ecosystem, you have the opportunity to have better allocation of capital which ultimately inures to the benefit of the policyholders and owners of the insurers. That said, it can be used for good and evil. And so there have been instances where people have looked at the rules state by state and otherwise and said, well, I'm going to manufacture something that looks like it doesn't ever default. I'm going to manufacture something that looks like it has high interest, but it's actually really risky and I will have to put a very small amount of capital against it. That's bad, and that's bad for everybody. I think overall the trend is having great investors who are thoughtful about the allocation of capital is better for the insurance industry generally, better for policyholders generally, in order to effectively meet their needs as policyholders and annuitants.
- [26:26]
B
The concern we have is we've already seen a couple of private equity control insurers, for example, PHL Variable, which was put into rehabilitation last year, and acap, which is owned by seven seven Partners. It's already had its Bermuda reinsurer closed down and the state insurer is actually considering closing that one as well run into problems and losses for its annuitants. When we kind of look at a lot of the private equity controlled insurers, we see leverage ratios of 30 times or 50 times to one fairly commonly our concern is were the pho variable failure kind of like idiosyncratic? Or given your view on kind of what's happening in leverage finance, do you expect more of these to come going forward?
- [27:07]
C
Without casting aspersions on anyone in particular, I'll refer to my prior mentor's comment about criminals with a capital or a lowercase c, right? So being highly, highly thoughtful about the optimization of risk based charges in order to deliver an optimized return period of risk to policyholders and equity holders is a good thing. Double hypothecating collateral and never having equity in your company in the first place is a bad thing. Right, and that's a different thing. And so bad actors emerge in everything. And look, there's a lot of complexity here and part of the reason, if you really looked at it, why this activity has emerged within the life insurance space versus for instance, the banking industry, right? Because many, many people have thought, well, gee whiz, it would be great to own a bank, right? Because there's similar, though not term matched liabilities there that one could kind of deliver this type of service to as well. Well, unfortunately in banking the homogeneity and general oppressiveness of the regulatory infrastructure basically precludes it. And that'll ultimately inert very much to the bank's detriment because great capital allocation can't get in there, so to speak. But insurance is balkanized in its regulatory environment, right? There's states, there's AM best, there's Bermuda, there's solvency within Europe. There's different rules in lots of different places in different ways, right? And so that balkanization and that heterogeneity has invited in people who are able to be more thoughtful for sure on the allocation of capital, but also it may invite in some folks who are clever enough to do bad things.
- [28:58]
A
I would submit, just as a matter of conjecture, that in a protracted credit cycle with lower and lower rates, with less and less attention to risk, that the infiltration, to use a somewhat loaded word of life companies by private equity would tend to lead to very aggressive investment techniques, very aggressive balance sheet structuring and more than a little reliance on captive reinsurance. And we see a lot of those one third of life companies apparently are now in the hands of private equity promoters. And it seems like the trends we have identified in the current issue of grants about the private equity owned sector of life business is part and parcel of what has been happening to credit more broadly, which is higher, faster, louder, more risk taking, less circumspection. There's something about the life business that seems to favor not really imaginative or so called great investment, but rather really dull investments that are undertaken with a perhaps over attention to failure and to default. And do you see anything wrong with that bit of conjecture?
- [30:29]
C
I do. I think what you're not taking into account is that before this phenomena happened, you had decades of subpar asset allocation, right? As we talked about with that proverbial multifamily apartment building, if it looks safe and it feels safe, doesn't mean it is safe, right? And so just because it's dull doesn't mean you don't have downside. And the answer is that legacy insurance has a large number of under $10 billion asset companies, frequently family owned, frequently very old. That in addition to having material competitive disadvantages in terms of legacy systems and practices on the operational and right side of the balance sheet, have real issues embedded already in investments that they made without necessarily fully understanding what they were getting into. Because if you have many, many billions of dollars of investment capital and you have only a few people, right, you know, got the grandson doing the, doing the bonds, right, that doesn't work anymore. It just doesn't work. You can't deliver optimized actuarial assumptions, product structures, and ultimately crediting rates to your annuitants that they will find compelling. And so in the absence of good investing, you will have what they call policy lapse. People say, I'm going to take my business elsewhere. I think having seen quite a few of these legacy insurers books quite closely, we have seen some very, very suboptimal practices in terms of capital allocation in things that on first plus you would say, well, that seems really safe, but it's not. They're taking more risk than they should have. They're not surveilling, they're not marking. We had someone who said, who had an overabundance of mortgages in a particular state and we said, well, why are you doing that? Well, we like this state. I'm like, I like ice cream too, but I need to eat other food in order to stay healthy. And so very, very basic things in many instances, in terms of how you optimize capital for the benefit of your policyholders that were not necessarily employed by these, by some of these particularly lower, lower scale legacy folks.
- [33:02]
A
Well, we'll stay away from the lower. Well, we, we mentioned New York Life and Northwestern Life as, as legacy players that, that seem to be not a part of the private equity drive.
- [33:14]
C
Can you say that about Northwestern? They just did a huge deal with 6th street, right? What a.
- [33:18]
A
With who?
- [33:19]
C
With a very talented group that gave them access to some of the things that perhaps traditionally they hadn't been able to create themselves.
- [33:27]
A
Well, getting away from life insurance, much to the relief I think, of some of our listeners. Tell us where you find the greatest risk and the greatest opportunity in the unconstrained fields that you survey. Sure.
- [33:40]
C
Well, I would say following the kind of slow moving train wreck discussion we started the talk with regarding the movement of or the recognition of losses, I think you can follow that path to find great investments and you can categorize those investments really along two lines. We call the barbell. On the right side of the barbell, there's the stuff where the value diminution has already happened and it's already well known and you can effectively buy the blow ups, buy the distressed debt, do the idiosyncratic new issue transaction that is a beneficiary of the difficulty already not only experienced but revealed on the left side of the barbell. There are tremendous opportunities to be a new investor, new issuer of credit in situations where the current participants have not necessarily fully revealed what's going on, but are far less aggressive in providing new money such that you can much more appropriately price it. So as an example, in US Corporate we would say we would not be a big fan of sponsor, you know, conventional sponsor lending, which people, many people just call private credit, unless it was situations like I described where we were taking advantage of already, of an already busted private credit situation. On the other side, we'd be very much more interested in, for instance, asset based lending on receivables, inventory machinery reserve based lending on oil and gas assets that have been unloved for a variety of reasons in venturing growth capital in certain instances where basically something that doesn't look as much nearly a shiny object as it used to for the venture capitalists can make real money, just not as much as they want and nobody wants to issue equity and there's effectively an overpaid credit transaction to do in real estate, there's going to be a tremendous opportunity to buy distressed real estate out of the banks and others in the coming years. It's just not there yet. So the value diminution has occurred on banks balance sheet. They just haven't told many people about it yet. And so you're not seeing the transactions. You are seeing opportunities to do new issue lending that makes a ton of sense and commercial mortgage lending in three to five year floatings in transitional bridges across many different product types. And then finally there's a tremendous opportunity to do what we'll call all things specialty finance that the banks used to do. Whether it's within factoring, trade finance, litigation finance, leasing of various sorts, small business finance, consumer lending. There's just a lot of stuff to do in all kinds of ways.
- [36:19]
B
At our conference last month, Viktor Klosov made the point that his pipeline of distressed deals is the fattest it's been since the global financial crisis. You're a specialist in finding companies that need help in terms of their capital structure or management, what have you. How big is the distressed opportunity that you see and how does it compare to other cyclical junctures?
- [36:39]
C
Well, Victor is very talented and has been doing this an enormous amount of time and is particularly good at buying these big chunky distress situations and really rolling up his sleeves and optimizing the assets. Most of where that at least traditionally has come from is in distressed leveraged loans. It can come from elsewhere, but that's where it comes from. I would argue to you that while I would agree wholeheartedly that the quote unquote pipeline is as big as it's ever been and only growing, the price makes no sense, zero sense. Now why is that? Well, it's because lo and behold we talked about the innovation around the thwarting of price discovery. So I see a company that had 100 million in cash flow, now it has 50, it's 11 times levered. And you know, if I look to 94, 98 or 102 or 08, I'm supposed to pay, you know, I might pay 30 or 40 cents for that and magically it seems to be indicated at 85 cents. So you go, that's funny. Could I see some information? Can I get information on that? And in 2005 the answer would be of course you can sign a non disclosure agreement. Here's all the information. What would you like to do right today it's no, nobody's going to give you the information. Why not? No one wants you to have the information. But if, even if we did give you the information, you're not on the white list that the private equity sponsor said was allowed to even buy it if you had the information right or you're on the blacklist and so we can't even show it to you in the first place.
- [38:04]
A
So this speaks to the overall speculative moment. No.
- [38:10]
C
Yes.
- [38:10]
A
And here's something else. You said that I thought it was the most striking in March of 2024 in our credit. Our distress event, I can assure you, by the way, is those are strong words about any market. Precious leeway for assurance. I've decided over the years. But anyway, you say I can assure you that there is a tsunami of terrible, terrible businesses and assets that need to be restructured. Rationalized. Sorry, rationalized. And the total addressable market, if you think of it that way, is bigger than it has ever been and growing. Close quote. Now we come. The CPI was out as we speak this morning and it is. The street has decided it is light. So that's good. So the game's afoot again and the Fed's going to cut rates in the teeth of. Evan, give me one example of speculative. Should we call it exuberance? Should we talk about the. Just briefly, what's your favorite?
- [39:12]
B
My favorite is a firm called Volatility Shares, a very aptly named firm just filed to register five times levered single asset ETFs. And these single assets are things like Tesla or Palantir or also crypto coins. Five times levered Bitcoin or Solana.
- [39:29]
A
All right. Okay. So that's, that's one side of the time. So in the face of what must be reckoned a very frothy marketplace, the Fed is going to proceed with rate cuts and in the teeth of the structure of these risks that you described so well last year. So how does one parse the chance of something really, really loud and troubling and costly happening to your portfolio with rationalizing that, with the opportunity and such opportunities as you have described. Now why Dan's word, aren't you in treasury bills and at home in bed with the covers pulled up over your head?
- [40:18]
C
Well, I would say I'd look to Charlie Munger who said, show me an incentive and I'll show you an outcome. And nobody in this picture has any other incentive other than to keep this party going or recognizing that there's an issue here, stretch out the amortization of the issue for as long as possible. And that's what you see every day. We are going to. That's why I mentioned over the next 10 or 20 years. Right. What happened in late 21 will be stretched out over an enormous period of time because that's in the interest of policymakers and financial sponsors. And so in the absence of something really extraordinary in terms of the left tail, right, perhaps Chinese troops showing up in Los Angeles, it's going to be very difficult for that not to be the case because it's in too many people's interest and you'll just basically see continued debasement.
- [41:12]
A
But in whose interest was the, was the 2008 affair and whose interest was the 1929 break, et cetera. Sometimes these happen despite unanimity of interest. They never should and never will again, right?
- [41:28]
C
Well, they do and I think they always arise from something you didn't expect. Right. Residential mortgages in 2007 were crazy, but so are many other things. And that's where it happened to start. And so is it possible? Sure. I mean, if you look at the performance reason recently on the BDCs, it was really kind of triggered by a combination of First Brands and Tricolor, which really don't have a lot to do with the BDC specifically. Right. That's what the real problem with it within BDCs is the fact that they, you know, particularly if they took on material credit risk before like 21, there's a lot of stuff in there that's difficult. Right. And that is, that is facing, you know, compressed margins and more, more difficult and more difficult economic environment. And so you wouldn't have expected necessarily those two things to connect. And so. Yes. Is it possible that you see something like that? Sure. Is it? I think if you're, if you're positioned correctly with, without inappropriate leverage with asset liability matching, when that happens, if it happens, you should be happy. Right. Warren Buffett was happy in 2008 because he had been doing things that made sense and was loaded with cash and could play offense. And so the question to ask yourself is, do you feel happy in an 08 situation? We actually say that to ourselves. What does this thing look like in 08? Are we going to be happy or not?
- [42:58]
A
What you know about 08 was it was followed by 09 and 10. Yeah.
- [43:04]
B
The amazing thing about 08 is we went from the highest high yield default rate then on record and within 12 months we actually went to below the long term average in terms of high yield defaults. Marty Fritzen, the kind of dean of high yield, came to our conference about a decade ago and said, I would say that's impossible, but it actually happened. And the reason why it happened was the Fed took rates to zero. A number of the problems for kind of these highly levered companies is they built a tremendous amount of Debt mostly in the form of floating rate loans prior to the Fed raising rates in 2022. And when the Fed raised rates, they suddenly had a huge increase in interest expense. SOFR right now is 4.24%. Do you have a sense of how much rates would have to fall to kind of bail out this leveraged edifice of probably 300.
- [43:48]
C
Right. But keep in mind, most people who are at least remotely thoughtful who've provided those floating rate obligations in the last few years have provided them with floors. Right. So they can do whatever they want, this SOFR. But if my floor is 4, then that's as low as it's going to. Right. And so I think people, many people who are thoughtful are positioned to be, quote, unquote, positively convex to that circumstance, right, where they effectively, by virtue of their floor, will have their spread increase.
- [44:17]
B
So say if the Fed took rates to zero again this time, would it actually bail out kind of private equity like it did in 2008, 2009?
- [44:24]
C
Yes, pretty much. Yes. It would be incredibly helpful to not just private equity, but to owners of financial assets, owners of real property assets that bought them pre, late 21 at rates that were close to zero. But the question then is again going to the New York Post article, why is this egg sandwich costing me $17? So you're going to be pushing on a big balloon, right? And it's going to bulge out elsewhere. You're going to see continued debasement of the fiat for sure. The question is at what point do we just, you know, is at what point do governments just repudiate? Right. It's a while off.
- [45:08]
A
Well, mercifully for this country, there is a whole new stash of gold available as collateral in the, in the, the ballroom building, so. Well, Dan Z. What a pleasure it has been to have you. We have this has to be more than one year affair. It's mostly, it's terrifically informative and you are very generous with your time. So thanks for being here.
- [45:30]
C
Thanks for having me, Jim. Appreciate it.
- [45:32]
A
So Harrison, I thank you and Evan, thank you. And until, oh, there won't be a next time for our current yield, we are going to speak to you next on the Jim and Evan show. Yes, until then, talk soon. Bye. Sa.