David Breazzano - High Yields and Low Risk at Polen Capital (EP.405)

0:04Hello, I'm Ted Seides, and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at CapitalAllocators .com. All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of capital allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

0:44Clients of capital allocators or podcast guests may maintain positions in securities discussed on this podcast. My guest on today's sponsored insight is Dave Brizano, head of the credit team at Poland Capital, where he oversees $8 billion of the firm's $43 billion in assets. Dave is one of the OGs in high yield, having started in the early 1980s and invested continuously through more than 40 years since. Our conversation covers some history of the high yield market alongside Dave's involvement in it, The founding of his firm in 1996, Poland's strategy to take advantage of myths in the market, the implementation of the strategy, and Dave's thoughts on the changing interest rate environment, private credit, and opportunities and risks going forward.

1:34In our complex world of investing, I suspect you'll find an elegance in the simplicity and clarity with which Dave approaches investing. Before we get going, in recent spread the words, I've introduced our newest Capital Allocators University for investor relations and business development professionals. It's a two -day event, December 3rd and 4th in New York City, where we'll help you learn how allocators think, prepare to put your best foot forward, optimize your experience at conferences, and learn what not to do from a panel of CIOs. I think our CAU for IR and BD is unique in the industry.

2:15At least I'm not aware of another opportunity to level up your professional capability alongside a group of your peers. We're excited to put this together for you and help bridge the knowledge gap between you and the allocators you seek to serve. You can learn more and sign up to attend at capitalallocators .com slash university. Hope to see you there. Please enjoy my conversation with Dave Brazano. Dave, great to see you. Good to see you, Ted. I'd love you to take me back from your early start in these markets and describe a little bit of your path and a little bit what the markets were like in high yield once you got started.

2:57Certainly. I started in high yield in the early 1980s. I had joined what was then the largest high -yield buy -side shop in the world, a firm called First Investors, where we managed over a billion dollars when the high -yield market was maybe 20 or 30 billion in size. It was a time when high -yield was viewed as a pariah -type investment class. Respectable people went into equities or investment grade debt, and it was more of the fringe players that went into high yield. And that's what attracted me. I was young, out of business school a couple of years, and I saw an opportunity in a pretty exciting nascent market that I think had a lot of potential so I could get in early as a pioneer.

3:49Drexel Burnham dominated the market, and they, along with a few other firms, realized they could develop a new issue market and bring to market some smaller companies or some companies that were out of favor. And then because of the returns that were being generated and the attractiveness of the yields that these securities provided, it started to gain popularity out of the 70s. And into the early 80s, we had a 20 % prime rate and interest rates were starting to come down. The population was accustomed to double digit yields on their CDs. The net was starting to go away. So the asset class started to gain in popularity because of the high yield and because of falling yields elsewhere in the marketplace.

4:40And capital started to flow in. In 1985, T. Rowe Price recruited me down to Baltimore to help them set up a high -yield mutual fund. This fund became, at the time, the fastest growing mutual fund that T. Rowe Price ever had. In May of 85, it was already $100 million in size. So it legitimized the fact that there was real demand for this type of product. And if one looked objectively at the performance of high -yield bonds and overlooked the myth around them that most of them will go bankrupt, it actually was pretty good on a risk -return basis. So the asset class continued to grow in popularity.

5:29In 1990, Fidelity Investments recruited me up to Boston to run their flagship high -yield fund and also to co -manage their bankruptcy investment area. Coming out of the late 80s in 1990, the high yield market went through a massive transformation. There was an insider trading scandal. And as a result, ultimately, Drexel was put out of business. The whole market went into a bit of a tailspin and liquidity dried up and the price of these bonds plummeted. So the Fidelity High Income Fund had accumulated a tax loss and senior leadership, Ned Johnson included, wanted to harvest that loss. So the concept was to bring me and this other bankruptcy specialist, Dan Harmetz, into their operation so that we could manage a high -yield fund for the income, but also incorporate restructurings and bankruptcy investments in that mutual fund to create capital gains that were effectively sheltered by the losses that had accumulated in the fund.

6:43And as a result of the strong performance and the popularity of the asset class, our fund size grew considerably. 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? 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.

7:35And there's some capacity constraints to take advantage of those. And then the market started to shift with the initial pariahness of high yield back in the early 80s 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.

8:20Now, 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 led to the creation of my firm DDJ Capital Management, which about two and a half years ago was acquired by Poland Capital. 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?

9:13Yeah, 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, 30%, 40%, 50 % a year. And I said, what if I told you it was 3 % or 4 % a year? And they go, oh, 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.

9:56And then take it one step further. When a bond defaults, what do you think it's worth? And I said, well, zero. And I go, well, it really isn't because you have a claim against the assets of that company ahead 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 40s. So if you look at a default rate of 3%, 4%, and if you get close to half your money back afterwards, your loss is like 2%. 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.

10:44And even today, that continues because our belief is if one looks at the data and looks at the return profile of, say, the high yield index, the vast majority of the returns generated over time is a function of the yield or the coupon on those bonds. It's not buying a bond at 90 and selling it at par and making those 10 points. There is some price action that certainly is involved, and there's some negative price action. If there is a default, the price will decline. But people often overlook that positives happen in high yield as well. A company can take out the bond prior to maturity and pay a call premium, and that's several points of additional profit that offsets any losses.

11:33Companies can get upgraded. They can go from single B to double B to triple B, and the spread compresses and the price goes up. So there are positive aspects that offset some of the negative aspects. So when one factors all that together, you observe that well north of 95 % of the return profile in the high yield market is the yield. So that leads one to conclude that, well, wouldn't it make sense to try to construct portfolios with the highest yield possible without jeopardizing the principle? And if one can do that, you would outperform others that don't necessarily do that. So if we have portfolios that have a significant yield advantage over the index or the market or our competitors and can contain the negative credit events, the default losses or price declines to be equal or less than the broader market, then you capture that yield spread essentially for free.

12:36And the compounding effect of that spread is significant over time. 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? 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.

13:29So we want to avoid those secularly challenged businesses where there's often a fertile ground for high yield investing. in 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, get 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.

14:22And 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, typically it will be rated CCC by the agencies. That's just the convention. They have an impossible job of trying to put a lot of risk factors in just a handful of buckets. So one is leverage, and that CCC rating will exclude a whole percentage of potential buyers and translate into a yield premium. And if it's high growth, low capex business sponsored by a sophisticated private equity firm, they've done their due diligence.

15:09We've done our due diligence. You got several eyes looking at it. And we come to the conclusion that this is a good business and it can handle that type of leverage. It's a good investment for us. Initially, you were talking about high growth businesses, low capex, 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? 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.

15:46If 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 2022 was a very low real interest rate environment.

16:32And 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. When you think about risk in the market you're participating in, the original interest in high 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.

17:13How do you think about the ongoing due diligence of whether something remains attractive in a significantly higher interest rate environment? 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 can do publics as well as private credit.

17:55In 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.

18:39So it's a dynamic process where we constantly monitor our holdings. Now, 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 high yield mutual funds out there will have hundreds of names. So it allows us to spend more time researching our companies because we have fewer of them. And we still think, statistically speaking, it provides more than adequate diversification. And we try to avoid over -diversification. So our analysts have the time and the experience to research these companies quite thoroughly.

19:27And if we don't like something about a company, since we're not obligated to own everything out there and there are thousands to pick and choose from, we could just move on, find another company. We're not forced to actually own it. So we make assumptions and try to anticipate worst case scenarios and ensure that under these worst case scenarios, in our opinion, the company is still solvent. It can mature the debt. Certainly, we don't bat a thousand. We make mistakes. So there will be companies in our portfolio that actually do default. And I will facetiously say to prospects or people, if we did not have any defaults in our portfolio and we have that yield advantage, then we're not pushing the yield advantage as much as we should.

20:20Because we should push it to, we have a couple defaults still in line with the market or less. But if we have none, that means we're leaving some potential yield on the table. So it's a balance act of how much yield can we get without increasing the default rate above the market average. How do you think about the value of liquidity when you're investing across public and private credit? 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.

21:16I 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.

22:05I 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 sometimes it protects you from doing something dumb. Now that's an oversimplification. But if you're a long -term investor, you shouldn't be so hyper -focused on liquidity. Make your asset allocation, select your managers, make your investments. And if you've done the fundamental work that you're supposed to do and you did it appropriately, you'll be okay.

22:50It'll work out. Now, one little side story I like to use as a difference between equity investors and fixed income investors is I think it's harder for the equity investors because they identify a stock and they make that purchase. and then they hope the next day or shortly thereafter, the rest of the market agrees with their investment thesis and buys that stock so that it trades up. If nobody agrees with their investment thesis, that stock could just go sideways forever and they underperform. So you're dependent on two things. You got to get the fundamentals right, but you also got to hope that others identify the same positives that you did after you and then buy it.

23:31In credit, we got to get our fundamentals right. And our sole job, or at least what I tell our analysts is just be certain in your opinion that that company can mature its debt. Then don't worry about where the bond trades between the day we invest in it and maturity, because if sentiment goes against us and people don't agree with our investment thesis and the bond trades down, if we did our work right, it goes back to par or to maturity or sooner. So nobody has to agree with us. We just have to get our thesis right and then we're rewarded. So it's a simpler process. We're just identifying 70 to 90 companies that we think are going to be able to pay us back out of thousands to pick and choose from.

24:15And the price action of those bonds over the course of that ride to maturity is noise. But we don't want to overreact and do something that we regret because if we did our work right, it goes to maturity and we're fine. So I will sacrifice liquidity for yield. How important is differentiating your research from others in the space? 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.

25:03And 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 -2 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. 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?

25:45Because 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 cash flow. But we also look at the loan to value. If the company were put up for sale, what would somebody pay for it? If there's a high amount of debt to enterprise value, even if the coverage is fit, we're not going to lend against it because it's got a very small room for error.

26:26But likewise, if there's a significant equity cushion or a low loan to value, and even if the credit coverage ratios initially appear tight, it could be eligible for inclusion in a portfolio because there's a high likelihood that if the company were to default, it could be sold for more than the debt or God forbid, we actually have to foreclose and own the company. We could turn around and sell it for a lot more than we lent against it. So this is where we often find opportunities that loan devalue because the market often doesn't distinguish as much as we do the importance of that metric. So we like to use an example.

27:13If there was two companies with six times debt to EBITDA, but one was a capital intensive, low growth business that had a total enterprise value of say seven times EBITDA, it's got a very small margin. It's in the 80s plus percent loan to value, very little cushion. Conversely, if there was a business that a private equity firm paid 15 times EBITDA for, because it's growing rapidly, has low capex requirements, and has a bright business future, and they put six times leverage on it, both companies will carry in likely a triple C rating. But one is 40 % loan to value and the other is almost 90 % loan to value.

28:01And they both have the same credit rating or close to it. And so we pick the second one. Facetiously, I would say, I hope it defaults. Because if I get to own that company at six times leverage, when the PE firm paid 15 times, I can more than double my money if they hand me the keys. But they never will. So that company likely will never default. And they shouldn't because they could just sell it if they were struggling servicing the debt or just put more equity in to save their original equity investment. There are a lot of levers they could pull to salvage it. So those are some of the things that we look for.

28:39And we constantly are monitoring the loan to value of our companies and underwriting them as if we were a private equity firm. What would we pay for that business? And that gives us another sense of comfort because we know there's an equity cushion below us. What has been the default history of your investments compared to the market? Our default rate has been in line with the industry in the twos. 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 40s to 50 cents on the dollar. And our recovery rate is significantly higher than that.

29:24Going 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.

30:09But 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 100 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 broader market. So we have this yield premium and we have net credit losses less than the market. So we've gone for a long time now without a significant sustained default cycle.

30:52There've been a few blips. I'm curious how you think about managing the portfolio in an environment going forward that may not be the same as what we've experienced in the past. My belief is it won't be the same as we experienced in the past. So part of our job is to try to anticipate how the market has evolved and what the differences will be going forward. And a couple of dynamics that we think are important to get our arms around is historically, the recovery rate for loans was higher than the recovery rate for bonds. Going forward, we think that's going to be different because of a number of factors.