The Exchanges

Q As you watched it evolve through cycles, through the original boom and bust, and then recovery from that, what did you take away as how you thought about what worked in terms of investing in the area?

A Yeah, very good question. So first, I recognize that the market was surrounded by misperceptions. There was this belief that junk bonds, the vast majority of them defaulted and would end up as worthless securities. So that was the myth. I remember asking people, what do you think the annual default rate is for high yield bonds? And people would say, oh, 3040, 50% a year. And I said, what if I told you it was three or four percent a year? And they go, ah, that can't be. And I go, but that's what it is. And if you look at the yield premium that one gets at the time, it more than compensated for that risk. And then take it one step further. When a bond defaults, what do you think it's worth? And they said, well, zero. And I go, well, it really isn't because you have a claim against the assets of that company that The head of the shareholders. And if the assets have a value greater than zero, you are entitled to it. And in fact, the recovery rate is in the forties. So if you look at a default rate of three, four percent, and if you get close to half your money back afterwards, your loss is like two percent. And if you have a spread significantly higher than that, you're going to outperform other asset classes. So I spent probably the early part of my career just developing narratives to dispel the myths and to get people to actually focus on the facts. And even today that continues…

AI assessment note: “if you look at a default rate of three, four percent... your loss is like two percent.”

Q To get at this opportunity set of finding the higher yield securities that don't have as much of a risk of default, what are the characteristics you look for within that universe to find the most attractive bonds?

A Essentially, we're looking for higher growth, lower CapEx businesses, so businesses that are throwing off a healthy amount of cash flow, but really what we're trying to do is avoid secularly challenged businesses. What Amazon has done to traditional brick and mortar retailers, and then that translates into Shopping malls and so forth, where you go through a traditional shopping mall that was vibrant 10, 20 years ago, and today it's a ghost town. So we want to avoid those secularly challenged businesses where there's often a fertile ground for high yield investing, and what we do is the private equity transactions, where the PE firms identify businesses that, in their opinion, are High growth, throwing off free cash flow, relatively low CapEx, and can handle a significant amount of debt and grow into their balance sheet. If they're exhibiting high single digit, low double digit growth rates, if they levered that business six or seven times debt to EBITDA with a mere passage of time, a year or two into it with that kind of growth rate, And the growth in EBITDA, all of a sudden, the leverage can come down one or two points, and that's significant. And that free cash flow can be used to pay down debt as well. So what started out as six or seven times leverage in a couple of years is four or five times, and then it's eligible for an upgrade. But if a company has six times leverage, …

AI assessment note: “Essentially, we're looking for higher growth, lower CapEx businesses”

Q Initially, you were talking about high growth businesses, low cap backs, secularly stable or growing high free cash flow. You don't associate that with high yield or junk bonds, but it's the leverage from the private equity firms that create the risk. Did I get that right?

A Yes. Poland Capital has a mid and small cap growth equity product. Some of her companies are companies that may find their way in our portfolio. If a PE firm identifies it as an attractive target, they can buy it and add leverage to the equation to support the premium price that they might have to pay to buy that company and take a private. So these are companies that exhibit those Positive characteristics in the PE firms, that's their business, is to look to see what they can acquire that can handle a healthy amount of leverage, which reduces their purchase price, their cash outlay effectively for the equity, and makes the whole equation work. Now, part of what happened over the last 10 to 15 years before twenty-twenty-two was a very low real interest rate environment, and that supported the growth in PE transactions and in the ability to acquire companies with a healthy amount of leverage because the interest costs were low. We'll see going forward at a higher interest rate environment if that changes the dynamics of that industry going forward, and I suspect it will.

AI assessment note: “Yes. If a PE firm identifies it as an attractive target, they can buy it and add leverage”

Q At some point in time, a while back now, almost 30 years ago, you left Fidelity to start your own shop, which continues today. What was that story of setting out on your own?

A I probably had an entrepreneurial inkling my whole life, so I thought at some point, wouldn't it be great to manage my own investment firm? So that was always in the back of my mind. But while I was at Fidelity from 90 to 1996, our assets grew tremendously. And as one AUM grows, it becomes a little bit more challenging to generate excessive returns. Where we saw the inefficiencies tended to be in little niches of the market, and there's some capacity constraints to take advantage of those. And then the market started to shift with the initial pariah-ness of high yield back in the early eighties to its acceptance and popularity. Everything went up market. Deals got bigger. It wasn't disrespectful to issue a high yield bond, and it fueled the growth of the private equity business. The big firms developed larger high yield funds, and they couldn't participate in some of the smaller, more traditional high yield deals. I saw an opportunity in the mid and small cap space that was being vacated as larger deals began to dominate the market. Now, all triple C's are not opportunities. In fact, we believe most of them are not good, but we believe That a certain percentage, 10, 15% of Triple C universe could be real opportunity because of the bias against considering them as viable investments. Those are the areas that we can exploit if we were managing a smaller pool of capital. So that l…

AI assessment note: “So that led to the creation of my firm DDJ Capital Management”

Q And that dynamic, how does private credit play into that?

A It's going to be interesting. There's been an explosion in private credit. That's a function of traditional bank lending going away and being replaced by money managers effectively. So there's three legs to the stool. There's public bonds, syndicated loans, and private credit, which typically is floating rate as well. Now, there's no reason to believe that in the aggregate, That the default rate between any of these three markets is going to be materially different. If you're company A, and you want to borrow money, you hire investment banker, and you canvas your options. Do you go public bond, syndicated loan, or private credit? Whichever market gives you the best terms, and it's not only interest rate, it could be covenants, maturity, and structure, but whatever the best terms are, that's where you borrow. But in a broadly diversified world of credit with thousands of companies and over a trillion dollars in each of these buckets, one should assume that there should not be a material diversion in the default rate between those buckets because they're all companies borrowing money and a certain percentage aren't going to work out. But secondly, what will happen in the private credit market is the company and its advisors can negotiate with the lenders A little bit more easily. If you have five lenders, it's easier to negotiate than if you have 50 or a hundred. So likely scenar…

AI assessment note: “what will happen in the private credit market is the company and its advisors can negotiate”

Q How do you think about the value of liquidity when you're investing across public and private credit?

A I mean, I'm biased. I think there is a rational value to liquidity. And the reason I say that is people value it and willing to pay for it. And then I say, well, what do you do with it? They'll say, well, if the markets change, then I could sell my liquid stuff and take advantage of those deep down opportunities. I can reposition my portfolio. And I go, okay, my experience has been when markets go into those situations, people freeze. They don't know what to do, and they're terrified of buying anything that went down. So they plan for it, and then never execute on it. Two, when it comes time to reposition, you're going to have to sell something to buy something. Well, likely, everything you own is down, so you're selling it down to buy something that's down, and you just got to make sure that Whatever you bought is going to move up more than what you sold. And that's a difficult thing for people to do. I've sat on investment committees, and I think in many cases, when you have too much liquidity, I've seen people do regretful things. You know, I talk to people in all the downturns and they say, my stock portfolio is down 25%. Should I sell? And I'll try to say no. And then I'll call them up a month later and they go, yeah, I sold. And they did it because they could. Whereas when something is illiquid, they say, well, geez, I really can't sell it. So I'll just ride it out. And s…

AI assessment note: “if you're a long-term investor, you shouldn't be so hyper-focused on liquidity.”

Q What has been the default history of your investments compared to the market?

A Our default rate has been in line with the industry in the tubes. So we're neck and neck with the index. But what's more significant is our recovery rate. The market history has been in the forties to 50 cents on the dollar, and our recovery rate is significantly higher than that. Going back to that example, if that company that had six times leverage and got acquired by a PE firm at 15 times, if that company defaulted, obviously the PE firm made a mistake. And the business didn't perform as they anticipated. And we probably made a mistake in our initial investment thesis. So the enterprise value came down considerably to where we were impaired, but the recovery rate there could be significantly close to what the leverage was or to par. And we've had situations where there were cyclical declines, where it was a cyclical business for a year or two, The revenues were down because of macroeconomic factors, but then we gained control of the company through a bankruptcy or restructuring process. And then when the economy or the business prospects recovered, the equity that we acquired through the restructuring appreciated in value. So we've had situations where we've made more than a hundred cents on a dollar a couple of years out. And then we've had situations obviously where we didn't do quite so well, but on average, Our recovery rate is substantially higher than that of the broa…

AI assessment note: “Our default rate has been in line with the industry in the tubes.”

Q So when you've had this sustained benign period for defaults, explosion in private credit, explosion in CLOs, probably less experience in restructuring, because there haven't been the kind of activity that you experienced earlier in your career. How do you think that plays out if you get to a recession, you have higher defaults, and you have a need for tools that haven't been employed in a long time?

A It's not going to be pretty. My advice would be to anybody that's looking to hire a manager is to really put a premium on experience. People that actually have been in the market before 2008. There are a lot of managers out there that tout their experience. I've been in investing for 1015 years, and I go, you never saw a downturn. You can't view that as Appropriate experience. Regardless of what anybody says, when things are going down, people panic, and they do things that they later regret they did. We saw it briefly with COVID, but it didn't last long enough. There are people that are going to see and experience things that they're unprepared for and take certain actions that they will regret down the road, but it'll be too late. The cycles do not go away. Defaults don't disappear. Whenever there's this flood of money, there will be a bubble and excesses are starting to appear and things will get a little rocky out there.

AI assessment note: “It's not going to be pretty. My advice would be to anybody that's looking”

Q As you look out into this changing environment, on the balance of super excited about the opportunity set, worried about what might happen, where do you sit today?

A As a credit investor, we all worry. I don't like to say naturally pessimists, but you gotta have some optimism that the company's gonna survive, but you always worry, what did we miss? Have we crossed every T, dotted every I, and so forth? So that said, but where we sit, I think we're fine. We've always been able to find opportunities. Now, will we find better opportunities? Next week, or next month, or next year, or worse, we don't know, because we can't determine where the market goes. So simply, if we buy a bond, and I'll just pick a number, that yields nine percent, and we've done our work, and we're confident that it'll mature, and it does mature, our return is going to be nine percent. Now, any month, it's going to bounce around based on the price of the bond, or what the Fed does, or what other people assume. But if we hold it to maturity, it's nine percent, and that's all it is. Now, next year, maybe I could have bought it at nine and a half percent. I don't know, but I might only be able to get eight percent next year. So we're going to buy that nine percent bond and hope we got it right, and we do most of the time, or we wouldn't be in business. So that's really it. So it's just a question of what the return profile is, and That's a function of forces beyond anybody's control.

AI assessment note: “As a credit investor, we all worry... but where we sit, I think we're fine.”

Q yield came when people used to get 10% on their CDs and rates start coming down. Now you have the opposite, where we're at the bottom of the cycle, it's coming back up, and you've had good businesses that find their way into your universe because of the leverage. How do you think about the ongoing due diligence of whether something remains attractive in a significantly higher interest rate environment?

A We constantly have to monitor our portfolio companies, and depending on the type of security that we hold, if it's a bond, typically we get quarterly information, and every quarter we can see the numbers that the company's generating and determine whether our investment thesis is still intact. We're agnostic to the type of debt instrument that we invest in. We can do fixed rate bonds. We can do floating rate loans. We could do publics. As well as private credit. In our strategies, we take advantage of all areas of the debt markets. And in our opinion, it's just the company borrowing money. We have to determine whether it's going to pay us back. We don't care whether it's a bond, a loan, public or private. We just want to get paid back. So with a loan, you can often get monthly financials. So you get real time data To determine whether the investment thesis remains intact. Occasionally it doesn't. Then we have to re underwrite the situation to decide whether we want to exit it or it's still solvent. It's still going to mature in our opinion, even though it underperformed what our expectations were. So it's a dynamic process where we constantly monitor our holdings. Now we're a little bit different than many other Credit investors. We run what many people would consider relatively concentrated portfolios in our opportunistic strategy. We'll have 70, 80, maybe 90 names max. Many h…

AI assessment note: “We constantly have to monitor our portfolio companies, and depending on the type of security”

Q How important is differentiating your research from others in the space?

A I think we all look at some of the same credit metrics, interest coverage and so forth, but we also like to look at enterprise value and loan to value. And I believe my experience in talking with other people in the industry, not all firms do that. So it's an important determinant for us. And essentially I like to equate it to a home mortgage. Just to make a simple explanation, when you go out and buy a house and seek a mortgage from what used to be a bank, now who knows who the lender is, they will want your W-II income, investment income you may have and all that. They spread your income and make sure that you have a healthy margin of income in excess of what the cost of that mortgage and home ownership would be and living expense. So your coverage ratio is So that's a clearly important determinant that they do, but they also hire an appraiser to go out and determine what is the house worth? Because God forbid you lose your job and you can't make your mortgage payment and the bank has to foreclose on the house. They want to sell it for more than what they've lent against it. And that's loan to value. We do the same thing with our companies. We look at all the metrics that other credit investors would look at to make sure that the company can service its debt. And maturity schedules and all the other calls on its cashflow. But we also look at the loan to value. If the company …

AI assessment note: “we also like to look at enterprise value and loan to value. And I believe”