The Exchanges

Q As you look at this massive growth in private credit and direct lending broadly, it's all happened Untested. Not just the three years you've been doing it, but we haven't had an economic downturn when this surge of activities happen. As you look out of what risks could come from this space, what do you see?

A Of course, we should all appreciate that the risks that hit are usually not the ones that we're worried about. Those of us who live through the pandemic, of course, appreciate that better than other generations of investors. The irony is that people have been worried about Private credit for a while because it's a fast growing asset class. The worry was cyclicality. Oh, when you get a recession, this hasn't been tested, right? Everyone's always terrified of recessions everywhere, particularly in direct lending. So what did the people who were running direct lending business do? They prioritize non-cyclicals. There was a period of time where there were a lot of energy loans in direct lending products that didn't work in 1516. And so the portfolios morphed towards Safer things. Business services, healthcare, and then the elephant in the room, software. Software was amazing because non-cyclical, mission critical. If I had barged into your home in the middle of the night three years ago and shaken you from a slumber and said, Ted, there's a recession coming in the U.S., but you must own something in corporate credit. What do you want to own? Before calling the police, You would have said, that's obvious. I want to own something in SaaS software related to cybersecurity. Because no matter what happens, no matter what recession we have, JP Morgan, Coca-Cola, Goldman Sachs, they're no…

AI assessment note: “amongst the worst performing SaaS software loans. Security names. RSA, Avanti, McAfee, Barracuda”

Q How have you looked at the infrastructure of AI? There's been a lot of big data center build out and some big loans going into that space.

A We've been referring to AI as the super duper micro cycle. We believe it's been the place to invest in stress and distress, thinking about industries that are going through major change. Part of that super duper micro cycle has not only been creating a fun little toy on cloud code or the LLMs or investing in venture names, but has also been financing power and data centers and other parts of it. We've been at the forefront doing that now for a number of years. Our approach has been A humble one, given the technological transformation that we see. We're not pushing ourselves out on the frontier of what you can finance, but it's a really interesting experiment in capitalism meeting technology. The gold standard is financing a box, a data center that is being used by a hyperscaler, being guaranteed by a hyperscaler that amortizes. Then you can feel comfortable that not only do you have a really important company of consequence, the Metas, the Amazons, the Microsoft, the Googles, Of the world, but you're also getting your money back in an amortizing way. That's the gold standard. There are then deviations from that. Is it just chip finance? Are you financing residuals? We've not financed long-term residual risk. We think it's been too hard for us, but this is America. Everything can be trunched. We've invested at the top of the capital structure in an amortizing way. There are cons…

AI assessment note: “The gold standard is financing a box, a data center that is being used by a hyperscaler”

Q As you look at that whole landscape and you picked building products, what are the most important levers in determining where you want to try to participate in the microcycle?

A Everyone's business is different. There are many people who do equities, and so they have a broader universe. We are blessed to be credit guys. We get to be a little slower. We look at capital structures that are over levered in businesses that can make a good return on capital. One thing that we emphasize at Diameter is what is a good business? Some people talk about management. Some people talk about margins. For us, we say, let's go back to first principles. What is the return on invested capital for the business? Simply take tax affected EBIT and look at whether it's PPE makes sense or the last five years of CapEx. Does the business earn a good return? If it does seem to earn a good return, why? Oh, there's only two guys who do this. They distribute to Home Depot and Lowe's and then through building products distributors. That's a pretty interesting business. So we're trying to find good businesses from a return on capital perspective that can get price when things come back. And where the debt is trading at a discount because it's over levered. That's really the sweet spot. Frankly, we don't want restructurings. Restructurings are painful. I've got to put faith in one judge to see the world in a way that we see the world. We'd much rather find businesses that might be over levered today, but have excellent management teams, excellent sponsors that we can work through on th…

AI assessment note: “We look at capital structures that are over levered in businesses that can make a good return”

Q How has the size and scale that you've created impacted your ability to influence a cooperative agreement or a situation where there's other creditors coming at you?

A We are very active in stress and distressed. For better or for worse. Sometimes it works really well. Sometimes it doesn't. What that creates is a repeat player dynamic where I don't think there have been many firms on more ad hoc committees around potential restructurings in court or out of court than us. There have not been more firms involved in more par syndicated loans than us from hedge fund side. I think there is a repeat player perspective that if someone is going to really screw diameter I'd like to hope that they don't want to do that because they think they'll be on the other side of us and we should have goodwill. We were in a situation two years ago over Christmas where, boy, did we get it wrong. We underwrote this thing in August and by December it was out of money. Really not our finest moment. And we're going to have to liquidate a company over the Christmas season, which is the worst possible thing you can do. There were two creditors in the stack who had over 50%, which by the way was a mistake from us. Don't want to be in a situation where A very small number of creditors can get to voting thresholds. What company called and said, hey, you guys have 51%. Amend the doc to let yourself be senior to everybody else and give us the two hundred and fifty million dollars we need to fix the business. One of the people said diameters in this, they're smaller. We want …

AI assessment note: “What that creates is a repeat player dynamic where I don't think there have been”

Q What was your first paid job, and what'd you learn from it?

A The first real job I had was the summer after senior year of high school. I got hired to work at the New York City Economic Development Corporation as an intern. We were working on bringing jobs to Silicon Alley in New York. This was the summer of 1997. I learned an enormous amount, but I also learned about the impact of office politics. This is a political place, Political job. And boy, was it political. Everybody trying to figure out where they stood, who gets invited to which meeting and when and how, what your seniority level is and it's government. So who gets a driver and who doesn't. I think that politics kills organizations. I love politics, right? I'm obsessed with politics, but office politics is deadly. I remember when I was at my last firm, once I knew I was leaving at the end of my time there, and I just focused on investing. It's never a better investor. It wasn't like, who's in that meeting? Who's going in here? Do they have more points than me? Are they getting this time? I just invested. It did great. We've gone crazy at diameter to have as little politics as we possibly can have. It's a very flat organization. It violates a lot of the rules you learn if you buy management books in the airport. We're very transparent. I credit Scott for really teaching me that. The first place I saw how just pernicious office politics are, what was an amazing job, I loved ADC, …

AI assessment note: “I got hired to work at the New York City Economic Development Corporation as an intern.”

Q What are you avoiding like the plague in that space?

A Once I go on a podcast and say I'm avoiding it like the plague, that means I'll see an interesting deal a day later, and then I worry. There's no such thing as Bad bonds. There's bad prices. There's very few things that we won't try to price. We have struggled to price chip residual risk. You're a creature of who you are when we were very involved in Hertz, both before COVID and then in its restructuring and its emergence. It was a successful distressed debt investment. Conrad Hertz had a problem coming out of their restructuring that they had too many Teslas. It wasn't only that people didn't want to rent Teslas. I think people Found Tesla's interesting to rent. They're great cars. The problem was the residual value was much worse than was modeled. Didn't have the history that you have with a internal combustion car of what is a Chevy Malibu going to be worth? 18 months later, after it's gone from MCO to Disney world a thousand times. What I worry about is do we have any clue what an H 100 is going to be worth in three years? If we don't have a clue, how do we lend against it without amortization or a guarantee? That's the area that we're least comfortable, but we want to be a place that is a capital solutions provider that we can price risk, and we're seeing all sorts of different risk that is exciting to price.

AI assessment note: “We have struggled to price chip residual risk.”

Q I want to step back on this concept of microcycles. What is a microcycle as you think about it?

A As human beings, as citizens, we don't want environments of upheaval. They're terrible for humanity. As investors, particularly investors who have an aspect of our business, we were interested in stress and distressed debt. Investing in recessions or credit cycles gives you the type of margin for safety that you crave because you're buying top of the capital structure things at a discount. For a variety of reasons, we don't have those type of cycles as frequently as we used to have. We haven't had a true recession that is coming from outside an exogenous force. Didn't impact it like COVID. In a while, oh, eight, oh nine, you had the endogenous buildup of the housing cycle. That was a big investment opportunity. And then you have the 2000 recession, but of course, nine, 11 played a role in that. What it means is the best opportunity for distressed has been micro cycles. Go back during just my career and Scott's career, when the muni market got blown up because of some choice words said by a famous analyst after the financial crisis, even the European kind of double dip Recession in the peripheral countries. Then the energy microcycle in 2015, 16. The California power microcycle, which most of California was impacted by in many counterparties. When Amazon and online retail upended mall based retail and mall based real estate. Then after COVID, what we've seen in telecom, we're se…

AI assessment note: “when a whole industry that has a lot of debt, Is impacted by”

Q If that risk you're identifying were to play out, what might that look like in that ecosystem?

A I don't know. I do think that ABF has grown dramatically. I do think that the assets are demanded by insurers and others. If you could not create structured products out of asset-backed loans, we should have said asset-backed loans is everything from a loan on airline parts, a loan on a plane, a loan on an engine, consumer loans from companies like Affirm, Pagaya, to we even looked at a deal where it was buy now, pay later for Botox. Which was an excellent transaction because people want to keep getting Botox and they tend to be high quality borrowers. All of those things. If that engine slowed, it would make it harder for insurance to have attractive assets and to earn the yields that they've been bidding. I don't think that it would create systemic problems. Just like every hedge fund in the world wants to call a recession constantly because they're desperate for the volatility. Everyone wants to constantly say, what's the next systemic thing? Because the impact of being asleep in oh eight and not appreciating that while subprime was small on its face, it had turned itself into every crevice of banks and therefore was a much more systemic problem. The impact of getting that wrong was so enormous that we all think about what are systematic problems here. The systematic problem would be that you'd have really bad returns in your interval fund. You'd have really bad returns in y…

AI assessment note: “The systematic problem would be that you'd have really bad returns in your interval fund.”

Q What are some of the other micro cycles you're excited about?

A I mentioned telecom. Telecom continues to turn. AI has become important for fiber. You need to get the data back and forth, fiber, and then it's become important in wireless, where spectrum is going to become more crucial as we enter. This inference phase makes me think of waiting for Godot again, because in many ways we're partially there while we're training, while we're doing other things. Fiber and wireless continue to be important assets. My partner, Scott, coined good terms for the highway and skyway. Of AI. That will continue to be important. Understanding how companies that their core business models might not be as interesting today, but they have an AI angle that's real. The other element I think that's fascinating in telecom is fixed wireless has taken over as a very important part of the broadband ecosystem. It was a 150% of the growth last year in broadband across the country. It's basically using excess capacity and wireless spectrum that T-Mobile or AT&T have to provide a broadband solution in the household. But it uses a lot more data than the wireless. We're just going around in our phones. It's upended once again, the telecom ecosystem, which historically all you had was a cable company for fast internet. And now in some markets, it's cable plus fiber. And now it's cable plus fiber plus maybe Starlink plus fixed wireless. This is an industry that was rewarded …

AI assessment note: “I mentioned telecom. Telecom continues to turn. AI has become important for fiber.”

Q You mentioned healthcare earlier, the healthcare microcycle. Where are you playing that?

A Healthcare is supposed to be stable. We know all about the aging of the population that impacts the economy. We know the demographic data. We know how regularly everyone gets the flu, but there's enormous policy volatility in healthcare. We have decided in the United States that every four to eight years, we want to take a 180 degree turn in our policies in terms of who runs the country and what they support, which is Crazy, if you think about the long-term history, that impacts healthcare almost like no other. Healthcare, because it's predictable historically, is a place with a lot of, whether it's healthcare services, hospitals, roll-ups, these roll-ups create enormous value for doctors and for sponsors and for others, but they've run into a problem because if inflation was high in labor in healthcare. And so if I take the fact that I had labor and healthcare go crazy, Because they had a labor problem before the rest of the country had a labor problem. And I take the fact that every four to eight years we change what administration priorities are. Medicare Advantage is great. Now Medicare Advantage is terrible. We want to get rid of Medicaid payments. We want to increase Medicaid. It's become a consistent opportunity to find businesses that should exist, need to exist, that aren't frauds, although you see them in healthcare more than other places. It's been an opportunity for…

AI assessment note: “we tend to stay away from things that are single product or single payer.”

Q Within all of the micro cycle investing, there's been lots of change over time in how creditors participate relative to other creditors or the company, those LMEs and other stuff. Where are we today in how you're assessing the landscape of other players in any of the credits you're underwriting?

A I joke, you can't have credit conference without a panel on creditor violence, which is exciting because people like UFC, and this is credit nerds trying to pretend that they're warriors. I sell very much included. There are norms and there are laws. Norms evolve faster than laws evolve faster than capital structures evolve. I have found one thing to understand is, and I was trained as a lawyer in equities. There are fiduciary duties to minorities. You could own 51%. You can own 80%. You can even own 40%. If you really screw the little guy, you have violated fiduciary duties to them, and you can be held liable for that. In credit, that doesn't really exist. The way the law has worked is, it's a contract. It's not being analyzed under fiduciary duties law. It's not being analyzed under what the securities laws say about fiduciary duties. It's contract. What does the contract let you do?

AI assessment note: “In credit, that doesn't really exist... It's contract. What does the contract let you do?”

Q As you look at the lending activity in SaaS companies and software, what are the different ways that you've seen loans that you think are good loans and maybe loans that you think are more risky?

A The hard part to that question is you have to answer the AI question, which is one of the biggest questions in our economy to answer. Waiting for Godot, the Samuel Beckett play, is all about what is the nobility of waiting? When you're waiting, what are you accomplishing? What's been interesting about the purgatory of the current situation is no one is happy with AI. Everyone wants AGI, despite the fact that our lives are transformed by AI already. We are not comfortable with AI. We want it to be AGI right away. The reason is we're spending so much money. It has to be much better. When you think about what the future is, we like to look back to two analogs. Analog one is the self-driving cars. If you spend any time in places like Los Angeles, you now see the Waymos everywhere. They work. There's a debate about just where they will be, how fast they will go, but they work. Go back 10 years ago, we were told they're coming any minute. Took a long time. The reason was, it was close. It was 98%, 99%, but if you're sending cars out to streets, it's gotta be a hundred percent. It has to be able to deal with deviations that aren't in the model and not kill people while it does it. AI, which works splendidly until there's a deviation. Agents are working well doing a lot of things, but they're 98%. They make mistakes. AI's not there yet for prime time, so we can't predict where it's goi…

AI assessment note: “The hard part to that question is you have to answer the AI question”