The Exchanges, every show

Q And what was your experience like on the street?

A Another buddy from Duke's dad was looking for an analyst at Smith Barney. My friend recommended me. I had a job in consulting at Anderson Consulting, which became Accenture, like a computer science programming job. Interviewed there, which was fortunate. Did that for a year as an analyst and became a sales trader at Smith Barney. With my math background, tried to get into equity derivatives. There was no seats. I got into interest rate derivatives at Smith Barney, which great first four years, then left there in 1995 to go with a senior trader who's an interest rate derivative trader to Citibank to become a credit derivative trader, which I actually didn't even know what that meant, but I trusted the guy and left with him.

AI assessment note: “Did that for a year as an analyst and became a sales trader at Smith Barney.”

Q Why don't you take me back to what led you into finance in the first place?

A I was a computer science major at Duke my junior year. A good friend of mine gave me a book. He said, I think you'll like this, and it was Liar's Poker. I read it in one night. Literally, it was a party that night. I stayed in my room, read the book in one sitting. I know Michael Lewis thought it was a way to dissuade people, but I took it the other way. I liked math. I liked puzzles. I liked risk, in a sense. Learned how to play poker with my grandparents when I was young. Hadn't really been much exposed to the markets, but after reading that book, I was like, this is something that fits me.

AI assessment note: “after reading that book, I was like, this is something that fits me.”

Q What happened over the couple of years you were running?

A You ran it for six years. I personally made a lot of mistakes in running panning. One was not necessarily understanding that we were in this low vol regime and it wasn't really going to change. Getting the macro right sometimes, even as a fundamental investor, is crucial. That was a painful lesson to learn. But we started off so hot in 2013. We're up 20% net that it's also like, oh, wow, this is easy. That's the worst thing you can think about as an investor. I think every day you have to assume you start with zero next to your name. You're probably going to have some hurdle or adversity to overcome. 2014. We're doing well. It got tougher. We're up one for that year. 15 was a really hard year. We were down five, then up five or six and 16. I just got tired of it, to be honest. I had too mature of a team. I was better as a manager training younger people. That was my experience at King Street. I learned that in real time. I had a talented team, but it didn't fit the way that I operated the best.

AI assessment note: “we started off so hot in 2013. We're up 20% net”

Q What would proper risk management look like in one of these products?

A Good risk management would be a bigger liquidity sleeve, so maybe more levered loan BSLs. Trying to minimize unfunded commitments would be good. Unfunded commitments, whether it's a delayed draw term loan or a revolver, no one wants those. There's like kind of a cost of doing business. That's why credit derivatives was started. Banks didn't want those on. Let's hedge them out. You're not getting paid as much and you have the same credit risk. That would be one. And then being transparent on what is in the portfolio. Apollo came out, we're going to mark every month. That's a good move. But having marks that are as accurate as possible, it's hard sometimes. I'm not saying that there isn't going to be variance amongst marks, especially on private credit, but really being good about marks. Whoever explains their portfolio the best, does that mean one pagers, which you get in an institutional fund, or does that mean it teach in? That's where I'd like to see it to go, even though you're like, well, how is that risk management? The better that you inform your investors about your process and the investments that are in the vehicle, whatever the vehicle is, the more comfortable they get, the less they're going to rush to the door.

AI assessment note: “Good risk management would be a bigger liquidity sleeve, so maybe more levered loan”

Q Should you circle back as the second thing that intrigued you when you were talking to Boaz about joining Saba, this something could happen big in this private credit space. How are you now thinking opportunistically about investing as some of these things are happening?

A It's been widely reported. We are tendering for one of the Blue Owl funds, their Blue Owl OBDC-II, which we're going to see if there is any demand for liquidity at a discount to NAV. It's new territory, so we'll see. We don't know if there's going to be demand or not. We think there is potentially demand. The space is three hundred fifty billion dollars of assets plus another hundred billion of interval funds. So, four hundred fifty billion plus some non-traded REITs. Big, big space. It's a small percent of investors that do get gated or looking for liquidity. It could be a decent opportunity to make an investment. If anyone else wants to top our bid, they can. It's not like we have anything proprietary in that regard. If we do become a shareholder, we want to be constructive. We hope for transparency, not only for us, but for all shareholders in every fund. That's the best way to get through this time. Through this stress, we're going to see secondary trading of private credit. How stressed that is, is TBD. It's starting to pick up a little more now. Obviously, it makes sense. Some of the best club deals that are the best credits are trading at par right now. If you want to buy any private credit loan at par, I'm sure you could get filled pretty quickly. We're thinking about that as well as potential opportunity set.

AI assessment note: “We are tendering for one of the Blue Owl funds, their Blue Owl OBDC-II”

Q investment management tech, request a demo at ridgeline.ai. And now back to the show. I'd love to walk through a couple of the issues that commonly come up. You mentioned two of them, leverage and marks, but when I start with the marks in the private credit world, when you look at loans underneath one of these portfolios, where do you have concerns that the marks may not be accurate?

A There's some obvious ones where you see, let's just say public BDCs that own the same club deal, the same loan. One BDC versus another, or two or three versus a fourth BDC, there's a massive variance, in a second lien especially, where you're like, wait, the first lien we know is stressed a bit, so maybe it's worth 90 or 85. Not that it's impaired, but we'll throw it out a bad sector. It's a stressed SAS loan, and it has a second lien. The second lien's gotta be below 85. Then you have one Where a bunch of guys are marking at 60, and then there's a fourth one marking 85. Come on, you can do better than that. Yeah, maybe if you marked at 70. So there's some wild variants, easy ones.

AI assessment note: “where you see, let's just say public BDCs that own the same club deal”

Q So you go to step away the second time, probably knowing that the slow pace wasn't going to work for you. How did you spend those next couple years?

A I left in 18. Then my kids were older. It was great to be with them. They were in high school or coming to high school and were super busy interacting with them and helping them navigate their days and assisting them. That was super rewarding. Going to see their event, helping them with homework, thinking about their college journey. I was definitely busy with that. I remember getting the advice when I left King Street, you should meet with as many people as you can. I was like, no, I want to try to help New York City. I want to try to be a teacher. This time I was more open. I would literally meet with anybody for coffee that was interesting. During that time, I met you for the first time. I was more open-minded about it, more relaxed about it. With maturity, you get some wisdom.

AI assessment note: “I would literally meet with anybody for coffee that was interesting.”

Q What were some of the other mistakes you made?

A Every manager at some level gets away from what they're good at. Sometimes that makes you uncomfortable and gives you bad wrist positions, so you stretch on what your comfort level was. For instance, I was in the Fannie Freddie Preferreds early. A good salesperson called me. He's like, this is a cheap option. This guy had a great nose. I was like, oh, that is, that does make a ton of sense. So we bought him at three. And they were at 13. I remember thinking, wow, now this becomes a legal bet. The delta went from a five or 10 delta to a 40 delta. That's not my strong suit. Even if it's not mission drift, you just have to get out of trades. There were a bunch of trades that we went into. They were in my wheelhouse, and then they did well, and they got out of my wheelhouse, and some of them were really bad reversals.

AI assessment note: “For instance, I was in the Fannie Freddie Preferreds early.”

Q What was your time at King Street like?

A It was awesome. It was a blur in a sense. I met a friend named Brian Higgins in the late nineties. When I was at Merrill, a friend of mine who was a salesperson knew them and we pitched them the idea of credit derivatives as a way to go short because they had been short in high yield bonds. This was a more efficient way to go short, non-recourse in a sense. We had a great relationship there. I talked to them when I was going to the buy side, they weren't ready. I went trade a prop for a couple of years. Then I was getting recruited as Fran for a reference. He's like, why don't you come here? At the time, I understood the credit markets, I understood derivatives, and how credit derivatives fit in, and the relationship between bonds and credit to the basis. I wanted to go deeper into distressed investing, thinking about value. It was magical in the sense that Fran was this amazing distressed investor, a great analyst. I had this other skill set, which not a lot of buy sides had, so the combination was so much synergy. Couple with amazing amount of volatility in the markets starting in oh five with some mini default cycle, then LBOs, and then subprime and into GFC.

AI assessment note: “It was awesome. It was a blur in a sense.”

Q in Q four, rates come down, cut the dividends, very rational, the yields are going less on floating rate notes. The other side of the underwriting is the default cycle, and it's very different. Private credit, one lender, one company, they can defer, pretend, extend, whatever it is. How do you think about how to measure successful underwriting as you're looking at the different managers that are offering these loans?

A You have to go line by line and look at where they have problem loans. How many of their loans are either marked below 80 or you think should be marked below 80? Hindsight's twenty-twenty. SAS was the darling of private assets, whether it's private equity or private credit or even venture. SAS was the darling of alts. If you're like, hey, I'm all in on technology, that's my thing. And there are some funds, non-traded or public BDCs. If you want that, this is what I'm giving you. That's what you signed up for. And we're in this period of how much is AI going to disrupt? If you think about economic, 80% gross margins, they're not going to last forever. Someone's going to try to figure out how to attack them. This whole, it's like switching costs, clearly technology switching customers. People are thinking about that problem. But I would say portfolio construction, if you're not saying you're all soft, I'm doing a technology fund, but I'm in 50% software, do all your investors realize that? Is that something that you have communicated to everyone? That's where you get the disconnect. We're going to have a wave of defaults in the software space. I don't think that's crazy to think about because we've had so much capital go into the space that from a venture or private equity standpoint, Hey, listen, the upsides are so amazing that we can take some losers. We can still do well. Vent…

AI assessment note: “You have to go line by line and look at where they have problem loans.”

Q What do you think most investors in this space misunderstand the most?

A Liquidity. I understand private markets and I have investments in funds. There's some advantage as being an LP and not being tempted to trade. I don't need that temptation. And that's okay if you're a GP of a private fund and you don't need liquidity. They're like, these are my bets. I made these investments. But when you need liquidity or you get liquidity taken from you, that's where traders come in. There are firms that have more of a trading talent on the private credit side, and there's some that don't. That's going to be the differentiator. When it goes away, truly, whether it's during the GFC or the early 2000 around Oralcom Enron, all that stuff, it's always shocking. Even if you're David Tepper, who probably has traded those markets as well as anyone on the credit side, I'm sure they were like, oh my gosh, I can't believe I hit that bid and it's down 20 points. Everybody has a plan until you get punched in the face. Like Mike Tyson, that's liquidity.

AI assessment note: “Liquidity. I understand private markets and I have investments in funds.”

Q You started early on in credit derivatives, bringing that over to the buy side as a short mechanism, distressed When it was still a cottage industry, how did you think about navigating the changes in the credit markets over the years of your career?

A I was learning from the ground up, coming over there, and there were still remnants of Enron's, which was a great case study to understand how you have this going through chapter 11, which for Enron was pretty much a liquidation. Credit drivers at the same time was developing complexity as far as all the tranches of indices that were trading in synthetic CDOs and correlation trading. That was all happening. I looked at what Fran and Brian were comfortable as investors. How does that translate into what I know? For instance, in late oh five, we had this many default cycle and auto parts and airlines. There were all these correlation trades that blew up such that when you were tranching portfolio credit synthetically via CDS, the equity tranche got really cheap. It reminds me today where you just had one or two sectors having a lot of stress like we have today and the SAS with respect to levered loans, and we're seeing it in CLO equity has way underperformed. The relative loan market, because all of the damage has been in one sector is the first loss, the equity piece. You're getting the brunt of that.

AI assessment note: “I looked at what Fran and Brian were comfortable as investors. How does that translate”

Q When you look at the volume of those situations, where it's easy that there's a wild discrepancy, how does that roll up into whether that's a systemic problem in the space?

A If you rated the big non-traded or public BDC managers on a scale of one to 10, ten's the best marker and one's the worst marker, what's the NAV difference? If the guy that's rated 10, he's at the top of the heap, his NAV is probably the most accurate snapshot for this. Obviously, there's delay here as well because they marked by quarter, which is Apollo trying to do. What is the guy that's rated one? What's the difference in NAV? Four or five percent, maybe six. It compounds a bit. Then you have micro situations where loans are getting marked from hundred to zero in one quarter. Everyone goes to the worst, because credit is about Believing. You have to believe. Credeer is credit means to believe. And when you lose belief, it happens really quickly. Trust is the biggest thing.

AI assessment note: “credit is about Believing. You have to believe... when you lose belief, it happens”

Q A lot of the past cycles were funded by a significant amount of leverage. What are you seeing in the underlying fundamentals of the businesses as it flows through to what you're concerned about in the structures of some of these credit vehicles and leverage?

A The alt space is always trying to be creative and look for opportunities as to where to deploy capital. This idea of ARR loans, no one would have done that. You would have gotten laughed at a bit that you're lending to a company that has negative EBITDA and you're not getting any warrants. That was venture lending. You're doing venture lending without warrants. Well, SAS had been a great model for a long time, but we're in a pro growth space. It's pro cyclical. I don't think AR loans are good risk reward. They work for a long time. Maybe some people did well with them. There's some investors that are great timers, and they know it's bad risk reward, but they can ride a wave really well. But I do think we're gonna have less AR loans if we do get this software shakeout.

AI assessment note: “This idea of ARR loans... you're lending to a company that has negative EBITDA”