The Exchanges

Q Within private credit, with all the explosion that's happened in the activity, the volume of assets to put to work, what are you seeing in the behavior of the participants?

A It's a fine asset class. What you're seeing is if new buyouts are the lifeblood of that business, and new buyout activity has been muted for the last several years, you're seeing a lot of competition in that space, and spreads have come down. You have an interesting environment where the height of direct lending was in 23. Because of the failure of the syndicated loan market, there were a lot of hung deals in 22, and banks lost a lot of money on paper. You had a major participant out And a lot of these direct lenders were financing deals that were getting done at spreads of 700. What that means at the time, S, the base rate was five and a half. Adding seven to five and a half is 12 and a half percent for senior secured paper. If you look at prices that were being paid for the assets, they were paying 18 times, 17 times. So you were a third into the capital structure being paid 13% on levered. That was nirvana. Everyone went all over the world and said, hey, forget equity. I can give you 13%. I can lever it in a diversified pool and make you 15. That caused a lot of capital to flood into the ecosystem. Now what you're seeing is those businesses are attached to a lot of very large alternative asset managers, many of whom trade on FRE. A good way to create FRE is to take several billion dollars of loans and charge one percent on them. That's what you're seeing in the ecosystem, so…

AI assessment note: “you're seeing a lot of competition in that space, and spreads have come down”

Q How's that impacted what you're saying in private equity?

A What I would say in private equity is you had a couple things happen. Rates were low for a long time. If you're paying 16 times EBITDA for something, and your capital structure is only six, The incremental pickup and basically spread and rate don't crater your LBO model because it's a small part of your structure. What it does do is hampers your flexibility, your ability to do real aggressive add-on M&A. If your coverage ratios are really tight, you have to have confidence about what you're buying. You can't just say, ah, I'll buy a bunch of stuff and see what happens. You're going to have real issues with solvency if you get these wrong. If you do a bunch of M&A and it doesn't produce the earnings you think again, and you keep levering yourself up on a pro forma number, You got to be careful, especially with rates going from zero. Used to be able to borrow Unitronch back in 21 at six and a quarter percent. Now those numbers are around nine and changed today. They were 13. You can get a sense of the impact of that. That impacted buy and build. The other thing in private equity is funds got raised, bigger and bigger funds. What's happened is that a lot of these assets are huge. A lot of these companies that are good businesses and business services and things with high margins that are Low capital intensity. A lot of them are valued at 1516, 17 times EBITDA. And if it's a 150 or…

AI assessment note: “What it does do is hampers your flexibility, your ability to do real aggressive”

Q So we can go from early banking to early hedge funds. What was that experience like?

A I was a good analyst, well-rated or whatever that is in the analyst program, but you realize a lot of that is just doing a lot of perfunctory things. When you step back after 30 years, you were making sure a deck got done. You were making sure the merger model was right. Back in the day, we didn't have the internet. We had to go down to the stupid IBIS machine and get the estimates off the machine, and we had to get paper stacks of SEC documents. A lot of that was navigating a process, making sure the deck was on. You're going down to WordPress. 30 years ago, we didn't have Excel. You had Lotus, one, two, three. You had to print it out and get word processing to transpose it. From there, make sure there were no mistakes in it. Put it in the book. Make sure the book's produced correctly. A lot of your job was that. Being good at that doesn't mean you're a great investor. It means that you're good at people yelling at you. It means you're good at handling abuse and being incredibly inefficient with your time, but you thought you were efficient. Then step into day one, I joined a hedge fund. And I was one of four or five people there, and I remember just the absolute pain and agony I felt of, I was the youngest person there probably by 15 years. In terms of real chops about what to do, I had no idea. My first week, someone asked me about a stock. Should we buy it or sell it, or wh…

AI assessment note: “Then step into day one, I joined a hedge fund... absolute pain and agony”

Q What'd you find when you got into private equity?

A I was in private equity in the late nineties through 2007. And at the time we were the top four or five largest funds in the world. It no longer exists. Sadly, a couple of things I learned raising a private equity fund. There's a lot of marketing behind it. There's a lot of IR math. There are a lot of stories. People didn't have his deep investment chops back then because at a time you could buy an asset for eight times EBITDA. You could lever it six. The LBO math did most of the work for you in terms of return. You weren't having deep level thoughts about the industry. You weren't doing advanced M&A or trying to buy an asset and heave off a bad part of it or do something creative. You were using leverage. The barrier to entry was, could you figure out Excel? Could you do that modeling? Could you convince a bank to give you the financing? It was a different business. I regret that the firm I was at didn't capitalize on it because it was a lot easier in the day. I also found basic things that when you have a team of people, because mostly private equity firms have different partners that do different industries, they have to get along, and there has to be management. What I learned is having a bunch of fiefdoms and people that have different incentives leads to bad outcomes. Aside from bad investments that I learned about day one, organization matters. Having someone driving a c…

AI assessment note: “The LBO math did most of the work for you in terms of return.”

Q Why don't you take me back to what it was like growing up in a family where you and your brothers all ended up in investing in finance?

A We were typical middle-class family in New Jersey. My dad was not in the business at all. He was an engineer. My oldest brother got into the business by accident. My mother knew someone that she played golf with. Her husband was a partner at Goldman, and she asked, what is your son doing? And he said, I'm going to go work for a big oil company and do chemical engineering. She casually said, well, have you thought about investment banking? No one in my family had any idea what that was at the time. My brother was a smart guy and ended up interviewing and getting a job. That's how my family accidentally discovered investment banking. I had another brother who's still in the business. He went through the process, and I was really lucky because when I was in college, I knew what an analyst program was. I knew the questions they asked you in interviews and all those sorts of things. Now, I wasn't a finance major. I was a liberal arts major. I didn't grow up with a dad who was obsessed with stock picking. I didn't have any of those things. I was very fortunate that I got exposed to a bunch of those analyst programs in the interviews and was able to figure out how to bumble and stumble my way through them, and I was lucky enough to get offers at a couple banks, and I went to Goldman Sachs. The big advantage for me joining that analyst program was since I never really learned a lot of …

AI assessment note: “We were typical middle-class family in New Jersey. My dad was not in the business”

Q Dave, I want to make sure I ask you a couple of fun closing questions. We'll finish it up. What was your first paid job, and what'd you learn from it?

A I was a caddy. I learned a lot, and this was in the eighties. I think a good loop was 18 bucks a bag. You were a self-contractor. You didn't show up with set hours. You didn't scoop the ice cream. You could choose not to work. You could choose to be lazy. You could choose to do only one loop. This is all on me showing up and doing this. I was 13, understanding that, work ethic, And then second, dealing with people. When you caddy, you see people cheat. You see people talk nonsense. You see people that are incredibly difficult, and they're stuck four or five hours together on a golf course. You learn a tremendous amount through osmosis. Then you learn how to be a good caddy. What are the most important things? Some caddies go overboard and talk too much and start telling stories and all that stuff, but they lose golf balls. My dad, he's departed, told me very early on, never lose a ball, ever. You keep up and shut up until you're spoken to. Always have a wet towel. What do people really care about? They don't want to lose their ball. They want to make sure when they go grab a club, you're right next to them. If you want to be charming, you do that on the side when someone invites you into a conversation, and you can say your witty thing. It's helped me to deal with difficult people. It's helped me the importance of work ethic, and it taught me there are some basic principles you…

AI assessment note: “I was a caddy. I learned a lot, and this was in the eighties.”

Q When you have that breadth of activities and relationships, what does that sourcing funnel look like for your business?

A It depends on what you're doing. If you are sourcing a direct lending transaction, you want to be in front of the capital markets person at a private equity firm, and that person's sole focus is to go out and try to secure an attractive cost of capital. Because that market has become more mainstream, those capital markets people know the people to call and know who can speak for what size. I don't want to say it's perfunctory, but it's a relatively straightforward process. When you're doing these hybrid instruments, we don't want to talk to the capital markets guy. Because generally we're expensive. If you're talking to someone whose sole purpose in life is to get the cost of capital down, that's not a good place to go into. What we want to do is traffic in a couple industries. The reason why that is, is there's nothing wrong with being an automotive supplier. There's nothing wrong with being a commodity chemical producer or drilling for oil. All those things are terrific. Buy equity. If you're going to go do that and take some risks like that, don't do hybrid capital and things that have more volatility or extremely capital intensive. And so we'll mine Parts of business services. Parts of software that we can understand. Parts of healthcare that are underwritable. Then we'll get deep in those industries. We'll do the conferences, and we'll get to know the individual deal partn…

AI assessment note: “It depends on what you're doing. If you are sourcing a direct lending transaction”

Q How easy is it to tease that out on the people side?

A It's hard. I have many flaws. I don't know where to start to describe them. My wife could give you a pretty long list. One thing I'm okay at is being pretty direct with people, but doing it in a way that doesn't offend them completely and getting answers. I like to sit down with people and say, why do you do this? Tell me about how you built it and what you were trying to do and tease it out. It takes a while to tease out to figure out like what makes someone tick. When I go and meet with management teams, I make sure our team's really prepared. If our team spends the first management team learning about a company, we failed. You want to be able to start asking questions where people are like, wow, these guys actually spent time learning my business. It goes a long way because people are like, wow, they're interested in what I do for a living. Step one, if you start building that confidence early on, They'll start telling you things, and you're not being argumentative and antagonistic. You're like, listen, I want to learn how this works. I'm interested. You can slowly tease out what gets people motivated. I've been in lots of deals where after talking to someone over dinner, I'm like, you're checking out. I'm writing you a five hundred million dollar check, and you want to retire. I don't think we're going to do this one. You have to figure that out, and people don't come out a…

AI assessment note: “It's hard. I have many flaws.”

Q When you're one of a few people able to provide this type of capital in the private equity ecosystem that itself isn't having easy liquidity, how do you think about the exit strategy for your deals?

A If you're doing that M&A deal, you're making a wager that that M&A deal is going to be transformative somehow. They're going to realize whatever synergies. They're going to create a different narrative about top-line growth. They're going to jettison some part of it that's slower growth, something that's going to change the narrative that maybe will appeal to the public markets, that maybe will get a strategic interest in it. That's part of what you're doing. And the second thing is when you're doing what I call the DPI trade or returning capital, sometimes those companies have run processes. And they weren't able to sell the company, and you're going to come in and provide them partial liquidity, and it's like, well, why am I so smart? Because they just try to sell it, and why do I think three or four years will be better? I wasn't born yesterday. You've got to do a lot of soul searching as to what's going to be different. It can be things from when they sold it, the two or three best strategics were doing whatever. That could be part of your thesis. They were tied up. It could be that There were certain macro things going on, or that they had leaked valuations that weren't realistic that caused people to stay away from this process. Maybe they need two years of proof of concept of one of the business lines that they're pointing to that no one believes yet. You've got to grab …

AI assessment note: “when you're doing straight preferreds, oftentimes they just refinance us out.”

Q As your team and the other people in the organization are teasing out what might be an opportunity, and there's some time sensitivity to it, what are the couple of signposts of what will get your attention as a deal that you might want to dive into?

A The first thing when we're sitting down as the portfolio manager for our business, if I don't understand what it is in the 1:02 hours, there's no chance we're doing it. I'm not saying that I'm any great genius. I'm old, and I've been doing this a lot. I've seen a lot of these business models. If I can't figure out what it does, or I have to make a bet on technology, or a bet on some commodity price, it ain't going to happen. Then we'll look at things and say, do we have any view on The three or four major top line trends here in this space. Some industries we're not very bullish on. Some we think are more attractive. Start with that. There are certain spaces we're not going to touch. I don't have a background on retail. I'm not going to go charging into a massive retailer and say, gee, if same source sales were higher, it would be great. So basically something we understand. We'll look at the business and say, okay, what are we doing for it? If you look at the two use cases for what we do, it's generally M&A or it's return of capital. And start with M&A. If it's small enough, a private equity owned company will use leverage. That's most accretive to its equity. However, if something gets big enough and they need equity, it can be difficult sometimes for them to invest in a company that they have marked up in the same fund and write equity check to go do that. If it's a large de…

AI assessment note: “if I don't understand what it is in the 1:02 hours, there's no chance”

Q What's the difference on the margin between a name you'll invest with and put in the portfolio and one that you decide not to?

A I've got to believe in the top line. My least favorite theses are value traps. I'm going to fire X, Y, and Z, and I'll be able to create an X multiple. Other people may do this well. In my 31, 32 years of doing this, that's always gone poorly. I will take top line Over terminating people, cutting costs all day long. I have to have some conviction. Why does it grow? Explain to me why. And it's not just, well, I took an Excel and I wrote one point oh six and I kept multiplying it. No, I mean, how do they sell this stuff? Do they have real pricing power? Who are their customers? You look in business services, they're sales organizations. I'll spend a lot of time saying, okay, if I'm making a bet on this company's ability to sell stuff, are they well run? How do the salespeople get paid? How does it work? It's top line. Every single time when I'm making an investment, I'm never going to pick a point estimate on a number. Where is my confidence interval around seven to 12% growth? That's difficult to do, to grow eight or nine percent consistently over four or five years. If you're underwriting that as your thesis, God, you got to have data. Not only data about looking backwards, but what is someone telling you that gives you that confidence going forward? What are you pointing to? That's the hardest thing. The other piece for me is who's running it. That's so important. We've made i…

AI assessment note: “I've got to believe in the top line. My least favorite theses are value traps.”

Q So you go back to the private markets. You have this disconnect and bottleneck between credit and the equity. As you mentioned, you're now in the capital solutions business. Can you talk about what that is and where it came from?

A In essence, it's any capital that's non-traditional. The first thing I alluded to was distressed. There is no distressed market. What's happening is, 30 years ago, there was a bigger premium to be in distress. If something were complicated or hairy or on the verge of insolvency, a lot of people said, ah, I don't want to deal with that. That's gross. So you had a bigger discount at play in that space. On top of that, you actually had higher carry. Rates were structurally higher. You could sit on a loan and And buy it at 75 and make a rate of return just by taking in the coop. When rates got super low and the notional yields were four percent, it was hard to make any money buying something at 77. More people came into the industry. What happened is distress only became interesting when there was dislocation. Right now, if you look at dislocation, during COVID, syndicated loans traded below 80 cents for eight days. During the GFC, 294. Big difference. The windows to take advantage are incredibly narrow. People realized very quickly, oh, this is a five hundred million dollar EBITDA software company, and it went from par to 78 because people freaked out that we were all going to be living in caves. That's silly. And that inefficiency went away. That's not a strategy. I always laugh and I tell my investors, people that show you the same decks that say wall of maturities. It's never h…

AI assessment note: “In essence, it's any capital that's non-traditional. The first thing I alluded to was distressed.”

Q Is there anything else that's interesting that falls into the type of deal structure you do?

A Occasionally, we'll do a new buyout. There are some terrific direct lenders that have the ability to do preferred. It's an auction. There are five or six guys competing on it. I'm going to back all of them. I'm going to run five trees. We're going to sequester information. No one's going to know what each other's doing, and we're not in that business. People are wonderful. That's a different business. It's a cost of capital business. The business that we like to do is imagine if you're a six billion dollar fund or seven billion dollar fund, and you want to do a high conviction deal. Well, you're paying 20 times for something, and you've got to write a 1,000,000,002, a 1,000,000,003 equity check. That check is large existentially for you, and ultimately, you're going to syndicate it to your limited partners. Before that happens, what do you do? Sometimes we'll come in and say, hey, listen, this is a big check. We're going to overcommit and preferred. The right hold size is three hundred million in this company. We're going to commit 500 or 600. There's different costs for those levels. The bigger the number, the more equity-like return it is, and down it goes. People, when they're in a bidding contest, I'm like, use me as your slush fund. If you need another 50, go ahead. That's very valuable to someone to know that you have someone who can move very quickly and will have a mini…

AI assessment note: “Occasionally, we'll do a new buyout.”

Q So after seeing that, that looked like it was going to be great, top of the world, doesn't go that well, where do you go from there?

A I went to a large hedge fund. This was the oh seven cycle when we were long in the tooth and people thought that the world might end. I pivoted to doing more distress stuff, loan to own, get into parts of the cap structure, become the fulcrum. The hedge fund was a quantitative hedge fund, had what we used to call our qualitative business. I thought it would be a fantastic pace. It looked like we were long in the cycle. Using our skills, especially my skills with things that had been broken before and having Learned how to think about those things and what's a good business, bad business. The aphorism, good company, bad balance sheet, by the way, never exists anymore. But being exposed to that, I pivoted to a large hedge fund that had a huge capital base to go do that. One of the things about this hedge fund that I worked at is it was incredibly quantitative. Tremendous smart people. That was one of the least exposed to what they did day to day because they were a blunt shop. The one rigor and things I learned, and I think back to this day, is one always Calculating you're up and you're down precisely. Hey, what am I playing for? What is my real downside? And I remember these to tell me, I don't want you to be conservative. I want you to be accurate. What I learned from them is, listen, we can take advantage of risk aversion. Often in the market, we get paid because people are r…

AI assessment note: “I went to a large hedge fund. This was the oh seven cycle”

Q How did those two things work together where there seems to be an endless abundance of credit capital available for a sponsor, but the sponsors have this pricing issue in terms of generating the returns they need to for their LPs?

A Credit's still hot. The uni markets are back to where they were. You can get six and a half, seven times leverage on the right assets if you need to. It's more expensive because of base rates, but spreads are very tight. Credit's not the problem. The problem is bid ask. If you looked at 2022, the S&P was down 20%. The NASDAQ was down 30%. Let's say private equity lives somewhere between those two worlds. Private equity was flat for the year. Compounding is pretty powerful. People now look at public comps. That's where you're having issues with these marks. You've never had any dip in the number. A lot of private equity firms, what you're seeing is the biggest institutions are capital formation machines. They're excellent. They're well-run. They're well-managed. The vast majority of capital being raised in private equity, I think the number is two-thirds, is the top 10 firms. What you're seeing is a shakeout in middle market. Middle market, by the way, is not tiny. It's two billion to fifteen billion somewhere in there. You're seeing real issues there. There are thousands of those players. You're seeing those folks with difficulty in returning capital. At the same time, some of them don't want to say, hey, this is a great asset. I think comps say at 17, I'm not going to mark it down because I still got to raise my next fund. That circle is pretty powerful. We're seeing a relucta…

AI assessment note: “Credit's not the problem. The problem is bid ask.”

Q How do you think about what your portfolio looks like in terms of the number of names, diversification?

A When we set up these funds, they're private equity-like. They're drawdown vehicles. We don't leverage these portfolios, so there's no third-party leverage on the funds, and that's important for a couple reasons. I couldn't get attractive leverage even if I wanted to because none of the companies pay interest. They're not senior secured piece of paper. My advance rate would be nothing. I would go through all of this mischigas and get no incremental return. If you believe that you are an alpha strategy, I think I'm getting excess return for doing this. I have some edge, whether it's structural, who I am, whatever it is. At the same time, I want to balance that because these names are not going to be five X's or six X's times our money. If you look at a PE fund, the way it's constructed, sometimes we'll have seven names, have a seven bagger, have a three bagger, have things marked in the middle, and some things aren't so good. And those offset. We're playing between one and a half and two and a half times our money, somewhere in that range. So you want to have reasonable diversification. 25 to 30 names. You're able to withstand a left-tail event. You have to be able to do that, especially with no leverage, but you can't have a hundred names, because then you're just doing anything, and you're participating in clubs. All of these deals, we typically author them, and we syndicate th…

AI assessment note: “So you want to have reasonable diversification. 25 to 30 names.”