Jeff Aronson – Building Centerbridge Across the Capital Structure (EP.468)

28:24Sure, compensation is important, but it's also culture. Young people, for example, who come here, it's a bit of a self-selecting crowd. If you only want to do buyouts, that's it. You're probably not going to even send us your CV. And the same thing with credit. It's people who are curious and know what they're signing up for. It's just a different experience. Not necessarily better, just different. What did you figure out about what in particular is complex from that simple idea of bringing the people together? It takes a lot of practice. It's natural. I'm going to go do my own thing and I'm focused on what I'm doing.

29:03I'm focused on the deal I'm doing as opposed to, yeah, I'm sure I'm doing my own thing. I'm running a deal. I'm doing diligence. But a big part of my job is working with my colleagues and making them better. And a big part of their job is working with you and making you better. That's a learned behavior. Takes time.

29:47see what Morningstar data can do for you. And now, back to the show. Are there any ways you tried to manufacture that to work better? Process is important. I talked about these weekly sector meetings. You just can't wing it. You actually have to have process. We talk about how we compensate people with the appropriate incentives. Team building is important here. We do a lot of team events as a firm. We have a foundation that we started the firm. Before it was a thing. Now it's a thing. Everyone has a foundation, but everyone participates in the foundation in terms of making grants and things like that.

30:24We have an open floor plan, very few offices. I didn't have my own office until maybe six years or so ago. I sat on the floor with everyone. Remember my parents once came here. Where's your corner office? I'm that chair. That was by design, all to encourage communication. How do you structure the compensation to keep everyone aligned? We have private equity funds. We have private credit funds. We have real estate funds. We make sure that people have meaningful components of their compensation come from across the firm. You still may have a major, which is perhaps a majority of your compensation, but a substantial minority, and I mean substantial, will come from other areas in the firm.

31:08You feel it culturally and your economics reflect it. You are truly part of one team. How do you cross-fertilize information across the different sectors to connect the dots? It would probably be more at the senior level, but that would be a bit more ad hoc. There's no formal process for that per se. What have you seen on the differences in underwriting from the concept of left-hand side of the balance sheet? They think about the growth and the right side's downside protection. When that gets into the underwriting of individual positions, what's subtly different than the two? There are different ways of approaching the same investment.

31:46People look at investment through a different lens. And that is one of the great things about our firm is that we can look at one particular company, but because we have investors around the table with different backgrounds and different skill sets and different experiences, it becomes a really interesting and vigorous conversation. What about this? What about that? That's what investing is. It's pushing each other and challenging, not in an aggressive way, but even our investment committee process. It's not that a deal team goes away for six weeks and then they show up with a beautiful deck. It's iterative, multiple investment committees and workshops and pushing and prodding and things like that.

32:27When it comes to owning positions on those two sides, credit, distress side, there's a lot now that the game theory of the different participants, LMEs, all that stuff, private equity, totally different. What are the lessons you've pulled out from when you bring those two things together? Well, hopefully the two never meet. We've had tough deals, like all bio firms. I am quite confident in saying that if we have a tough deal, we know what to do better than most, not just in terms of thinking about how to improve the value of the business, but what do we do with this capital structure? What's the best way to preserve value and grow.

33:05The tenure of partners here is very, very long. People, they get it. They know enough to ask questions because it's so collaborative. In the last 20 years, you've had a bunch of different types of cycles from GFC, sector cycles, pandemic rates now. Also, there aren't really legal bankruptcies or haven't been a long time the way there were. I'd love you to take me through what you learned in these different cycles and how you adapted the investing approach. All cycles, they're different and they are few and far between these days. I do believe in cycles. Predicting the timing of cycles is impossible.

33:46As I look at the world today, there are lots of manifestations of what I'll call late cycle behavior and signals. But as the cycles have progressed, so the last big cycle was really a GFC. COVID was brief. And what happened as a result of that? If I think about opportunistic credit, for example, opportunistic credit, investing in credit to make an equity-like return, it's been around since the 19th century. There was a speculator named Jay Gould who bought up railroad bonds post-Civil War. So it's been around through the 20th century through the depression. And it was always marked by two things.

34:25One, it was a strategy focus on markets, secondary markets that you bought a defaulted bond, a fallen angel, or even a loan from a bank, but you bought it in a market. And second, it was a total return opportunity. Not yield because companies bankrupt, there is no yield. So it's buying something at 70 that you thought was worth par. And what happened after the GFC, we know the story, banks retreated, Wall Street hates vacuums, non-bank banks came to the fore, this notion of direct lending. Credit started shifting away from banks to non-bank lenders, principally lenders that were financing buyouts.

35:10What did that mean for opportunistic credit, which again, had focused for a long time on secondary markets and trading and total return, we started evolving our opportunistic business post-GFC, particularly in the early to mid-teens, 10, 11, 12 years ago. In addition to keeping that traditional playbook of markets and total return, we started getting into the origination business. It was an evolution from pure secondary market focus to now focusing on primary origination. And from a return perspective, migrating from a total return strategy to a strategy that was focused on yield. So we started lending money, but we weren't lending money at LIBOR, the predecessor to SOFR, LIBOR plus 350.

36:00We wanted to do it at how's LIBOR plus 900 sound with all types of bells and whistles and covenants and structural protection and call protection, the result of which was to generate the same equity-like rate of return. And that was really a sea change in opportunistic credit investing to the point that it's more than half our business now as opportunistic credit investors. We're lenders and not just LMEs. In fact, LMEs are only a small portion of it, but it's transitional capital. It may be capital needed for growth. It may be capital to non-sponsor businesses. That's where most of our business is.

36:38It may be capital to a sponsor that needs capital and doesn't want to part with equity because it's too expensive, but it's some hair on it. It's complex. So it's not a traditional direct lending solution. That's been a huge change in our business. As you've evolved before you were an owner, how do you think about the differences in risk reward, particularly when those loans themselves are complex and maybe there's some hair on them? In investing in credit, you have to remember the three Cs. Capacity, which is the ability to pay. There is collateral, which is the guarantee, the backstop to pay.

37:16And then there's character, willingness to pay. Those are timeless. You still have to focus on all of those. I look at what we've done in our lending business, rate returns for a long period of time and dozens and dozens of deals, billions of dollars of capital with minimal losses. That's a function just being careful. Think about safety, safety, safety, safety. There's less of a focus on safety today than there used to be. Again, another manifestation of late cycle behavior, but safety first. When you invest in credit, particularly when you're originating, you lend a hundred cent dollars, you have to get back a hundred cents because your return is purely contractual.

37:56There's no convexity on the upside. You can only make so much money. So you have to be really careful to be good at this. I'd love to turn to where we are today. What do you mean by late cycle? Having seen past cycles, they're all different, but there are certain behaviors which always come to the fold. Cycles of tension between fear and greed, and we're very much in greed mode now. There's tremendous complacency. You see it in spreads. Spreads are super tight. They're tighter now than they were before the GFC in the investment grade world, which is mind-blowing, spreads tightened the tightest level since pre-long-term capital management in the late 90s.

38:38You see investors willing to accept opacity rather than transparency. You hear the phrase, got to put the money to work, deployment, deployment, deployment, far more than risk and safety. You see a spate of frauds. All of these are indications of late cycle behavior. It doesn't mean that things are going to turn tomorrow or when they turn, it's going to go kaboom. Who knows? But you just have to be really careful. And everyone has done well for a long time. It's ironic, but when you're on a hot streak like that and you think you can do no wrong, risk is rising. Even though mentally you're thinking, oh, I must be good.

39:23I got this. I got it covered. What are you seeing in the operating performance of the businesses you're either lending to or owning? We have not seen softness. Any given company can go through a patch. We have some building products companies that we own. They're going through some stuff now. We haven't seen a particular sector of the economy start to keel over. And we listen carefully to what banks are saying, what lenders are saying. And we have big credit exposure. We see it. We have multiple angles. We don't necessarily have to go to an economist at a bank to understand what's happening on the ground.

39:57We have our own private data set, our library. We talk to our portfolio companies. We talk to the management teams. I'm always anxious because I'm from credit land. We don't see it. You wonder about subprime auto always blows up as long as I've been doing this for nearly 40 years. Always it's constant. People do dumb things. I like to say one of the best things about working on Wall Street is people can't remember what they did yesterday. People make the same mistakes. Everyone always says they're careful, but you got to do it. You got to say no to deals. How do you invest through this environment?

40:31Carefully, nervously. My role at the firm has also evolved over a long time. My role now, I'm just focused on risk from an investment standpoint. You have to trust the judgment of your partners and your colleagues. And we've been together for a long time. And I know that everyone has strengths and weaknesses, including myself. I try to be cognizant of that. But my job really is, looks like we're going to drive into a wall. I'll say, don't do that. So, be really careful. When you bring that down to your sector meetings, your investment decisions, how is that impacting the incremental decision in any of the portfolios today?

41:14I don't know if it's impacting individual decisions, but people will generally know that I'm going to approach things. I'll be very curious. What about this? What about that? Have we thought about this? Have you reached out to this person? You got to be creative and trying to get an angle. We're looking at some businesses in the UK, which are regulated now. Well, how's it work in the EU? Even though the UK is not part of the EU, how's it work here? How does it work in Asia? What makes a good investor? I think it's the ability to see something before someone else. It's the ability to see something before someone else.

41:52And that's what we're always trying to do. Where does that vision come from? Some of it is learned and some of it is who you are. I always ask when we're interviewing someone or talking about someone, I'll say, do they get the joke? Do they really get it? Some of it is intuition. You got to be a very hard worker. You have to be detail-oriented, but you also have to be a good decision maker. And a lot of it is intuition, pattern recognition. It's how someone is built and it's years and years of doing it. So it's both learned and it's somewhat intuitive. I'd love to turn to talking a little bit about the business that you're in.

42:31That's also changed quite a lot the last 20 years through all its business credit. it. Just love your perspective on where you sit today in that ecosystem. We sit in the middle market. I'm happy we sit there. We have just under$45 billion of capital. It's a ton of money on the one hand. On the other hand, it's not compared to some of the giants out there and some of the public alternative managers. What we have decided to do is to stay focused on mid-cap, on middle market, but think about it in terms of full spectrum investing. We have fully built out private equity business, a fully built out private credit business, a fully built out real estate business.

43:15A lot of the giant managers of the world, the big public ones, they have the same. You'd be hard pressed to find another firm built like us in the middle market. That's how we approach it. That's our edge, obviously our people, but it's the part of the market we play in. It's our sourcing capabilities within that. It all goes in the mixing bowl. What are some of the competitive challenges you face on both sides? Just start with, you're in a market where there are much larger credit providers. I'm always thinking, how are we going to compete if someone has$300 billion in credit? There are two principal ways.

43:56One, we either have to be better at it. We have great investors that ultimately manifests itself in a record. Look at our track record and I feel pretty good about it. That means we have great talent. That's one way we can compete against someone with hundreds of billions of dollars. The other way we can compete is, and I use the phrase reluctantly because everyone uses the same damn phrase, is proprietary sourcing. I'm sure, Ted, everyone you speak to as proprietary sourcing? I think we really do, and it's demonstrable. So we either have to understand something better than anyone else because we've got great investment talent, or we need a sourcing channel that just belongs to us and can't be replicated.

44:38The third thing that we do goes back to the beginning of the firm. Operating as a single team gives us an advantage, both in terms of the skill that our investors have, because they do have a broader perspective than, for example, someone who only does credit. And I think it gives us access to different sourcing channels compared to someone who does credit. It's those three things. It's talent, it's sourcing, and it's our operating model, operating as one team. When you're seeing that late cycle behavior, particularly in the credit markets, how does better talent end up translating into returns if someone's looser at underwriting or willing to pay more?

45:21I'll give you two examples in the news. First Brands and Tricolor. We looked at both for years. People said there's never been a picture of Patrick James. We flew to his office. We met him in person. We had the Tricolor management team at our office. We spent a lot of time with both these businesses. We didn't invest a dollar. How do you measure that? That's a good question because we didn't do it. So how does that show up in our returns? Well, I guess we avoided a loss. That's a good thing. The fact that we didn't do it is real alpha. I think it's undeniable. I still don't know how to measure it, how to quantify it, but it's a real thing.

45:59And how about relative to smaller players in the credit markets, competitive disadvantages? One of my acronyms around here is ROE, which is what I call return on effort. we won't look at something small because the ROE is lousy. Won't move the needle on our fund. The same way that Apollo or Blackstone or KKR may not necessarily look at a mid-cap investment size because it doesn't do it for them. It doesn't move the needle. One of the things you mentioned earlier is IG spreads are tighter than they were pre-financial crisis and probably one of the proximate causes, the lower cost of capital of insurance subs at some of the big asset managers.

46:38How have you thought about the strategic activities that you've seen in accessing capital at some of your competitors? We've done the same. We have a longstanding relationship with MassMutual. We have a partnership with MassMutual where we're managing credit assets for a reinsurer called Martello Re that we put together with MassMutual and some other institutional investors. That's a perfect example because we weren't going to go build an insurance company from scratch. So we partnered with one. What we've done with direct lending, how are we going to compete with direct lenders who are focused on financing sponsor buyouts when that's an incredibly competitive business?

47:23And we know that business well because we're a sponsor. So we know how competitive it is. And credit investors have a lot of capital to deploy. We partnered with Wells Fargo to focus on companies that have nothing to do with Wall Street, that are family-owned. We've tried to do this with great intentionality, find partnerships that will enable us to compete at the highest levels. We're not competing with MassMutual. We're not competing with Wells Fargo, really important, but that enables us to compete with managers who are in the megaspace. What do you think happens with the renewed interest from private wealth coming into private credit, potentially private equity?

48:05It's a question of when, not if. I think alternatives are perfectly appropriate for individual investors with one gigantic caveat. They have to understand what they're buying in terms of the risks, in terms of liquidity, and in terms of the fees. And there can't be any obfuscation on any of those things. If people go in eyes wide open and they know what they're buying, I think it's perfectly appropriate. The challenge will be is that they don't and they do it anyways. That's an area for concern. There's a regulatory pendulum. A lot of capital will come in from the wealth side. Inevitably, there'll be an issue and it's just the way it is.

48:46I don't know what it'll be about, but there'll be something. If we're now dealing with small investors who don't have the sophistication level of a large university endowment or a big pension plan or a sovereign wealth fund, and it's perceived as the little guy is being hurt, well, then you could see regulatory backlash, even if the providers have done everything correctly. I think that's a known risk going in. It could happen. It wouldn't surprise me if it does happen sometime down the road. But that doesn't mean that a bad incident with a lousy outcome shouldn't impact an entire marketplace.

49:26Where do you think CenterBridge goes from here? Firms like ours were faced with a choice of, do you want to remain small? Do you want to be in the middle or do you want to be large? Being in the middle, you're not going to shrink your way to greatness. You have to grow. We have decided to grow. We've grown a lot over the last five years in terms of strategies, mostly but not exclusively that are credit related because our view has been, we should grow. but only in adjacencies. So are we going to start a long, short equity fund that focuses on stocks in Latin America? No, even if it's the flavor du jour, even if there's tons of enthusiasm about it, we're not going to do it.

50:12We have no edge, number one. And number two, it does nothing for our existing businesses. If you look at how we've grown, it's always been in adjacencies that we understand. And it's always been in businesses that will enhance our entire franchise. It broadens the funnel. We've been able to do that as opposed to let's just go do something because it happens to be topical today. If you could snap your fingers and fill asset capacity at whatever size you thought was optimal for what you do, where would you go? I like the idea of doubling our AUM over the next five years. Pretty ambitious, 15 % CAGR between performance and growth.

50:57That'd be good. When you look at the evolution of the industry over the 40 years you've been involved, what most concerns you? I would say commoditization. At some point, alternatives are no longer going to be an alternative. And they're like mainstream. And when that happens, it means it will be harder to generate outsized returns. That's what worries me. I think about that in terms of influx of wealth capital. All that capital is going to come in. It's going to need a home. What does that do to returns? Usually, more capital comes into a space. Returns tend to be depressed or decline. So it could be harder to outperform unless you're doing something that's niche-y, unless you have world-class talent, unless you do it differently.

51:46So I would argue we do it differently, our operating model, unless you've got sourcing channels that no one else has. There are lots of ways to address that. At some point, alternatives no longer be an alternative, which is the height of irony. What are you most excited about in the opportunity set for the next couple of years? The fact that it's changing so rapidly is intellectually quite engaging and exciting. How do we stay ahead of the curve? And we're not a mega firm and we don't want to be a mega firm, but how do you stay ahead? How do you make sure that you don't become commoditized? Everything we do, we think, what's our edge?

52:24So all those things that I just described, it's all about finding the right edge. And what are the things today that you think on the margin are new or different in how you're staying ahead of the curve? It's capitalizing on what we already know, what we've done with our insurance solutions business by partnering with MassMutual and now talking to other large insurers. That's different because we're not competing with them and we have no aspirations to compete with them. What we've done with Wells Fargo is pretty novel. There've been lots of copycats. That feels good. Imitation is the sincerest form of flattery.

52:58Those are two recent examples. So Mark retired a few years ago and you are still full on. What do you think it is that keeps you going? I love what I do. I find it intellectually interesting. I love the people I do it with. As a group of partners, we've been together a long time. My son is also in the investment business and he used to work at a big bank. And one day he was bellyaching to me and I said to him. Did you ever hear the expression, work sucks? And he goes, yes. I said, well, that expression is there for a reason. Sometimes it does, but the most part, it doesn't. I like the notion of building.

53:36The past five years, that has been a new thing for me. In addition to investing, which I've been investing since the 80s, building is also rewarding intellectually. It's really been fun as we build some of these adjacencies. It's an opportunity for young people who work here to take a leadership role. I find that rewarding. And I don't mean financially, I mean, almost emotionally, intellectually. Jeff, I want to ask you a couple of closing questions before I let you go. What is your favorite hobby or activity outside of work and family? I love to ski and I love to cycle. I like both of those because when I'm doing both, I'm focused on saving myself and my mind is not drifting back to my office in Midtown.

54:22I'm just focused on the moment. What was your first paid job and what'd you learn from it? It was an after-school job in high school. I worked at a high-end butcher shop. My job was to clean. I know how to make hamburger. To this day, I can wrap any type of deli meat or steak in the blink of an eye and it looks perfect. I remember that job vividly. What's your biggest investment pet peeve? second guessing. I'm an even keeled person, but when people get into the shoulda, woulda, coulda game, it drives me bananas because we all make mistakes. It's the nature of investing. If you're a professional, you don't need to be told by your coworkers, we should have done this, could have done that, it would have done that.

55:09The money is gone. It's lost. It's water under the bridge. You have to learn from that. If you're a professional, you know you don't need to be second-guessed by colleagues. That type of behavior is culturally corrosive. It's the only time I get agitated. Jeff, last one. How has your life turned out differently from how you expected it to? I am so lucky. My parents are elderly, but they still joke with me. Why do you give up law? I said, well, at first that was in the 80s and this other thing has worked out. I'm incredibly lucky. I am fortunate. I've done really well. My wife and I were giving away all our money, which is fantastic.

55:48And for all the stuff in the country, this is the greatest country. How did it turn out different? I had no idea I'd be sitting here and I'm here and hard work and luck being the right place, right time. Jeff, thanks so much for sharing your insights. Glad to be here. Thanks. Thanks for listening to the show. If you like what you heard, hop on our website at capitalallocators.com where you can access past shows, join our mailing list, and sign up for premium content. Have a good one and see you next time. 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.

56:26This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of capital allocators or podcast guests may maintain positions and securities discussed on this podcast.