Jonathan Lewinsohn – Credit Microcycles at Diameter (EP.484)

25:12We 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 distress 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 Teslas interesting to rent. They're great cars. The problem was the residual value was much worse than was modeled. You 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.

25:53What I worry about is, do we have any clue what an H100 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. I want to step back on this concept of microcycles. What is a microcycle as you think about it? 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.

26:33Investing 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, 809, 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, 9-11 played a role in that. What it means is the best opportunity for distressed has been microcycles.

27:14Go 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 and 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 seeing now in housing, we could see in software. It means when a whole industry that has a lot of debt is impacted by either technological transformation or policy volatility or both.

28:01And handling things when you have a lot of debt is the problem. Part of the reason we've been more bullish on the economy than some others over the last few years is the U.S. consumer and the corporate have been historically under levered. Debt acts as a boot on your neck. You cannot innovate. You can't spend. You can't do things if you have debt. Imagine you take out a mortgage you can't afford, then you lose your job. You're going to stop spending immediately because debt operates that way. Microcycles are caused because industries have too much debt to pivot and do the innovative things they need to do because of change.

28:36Creates enormous opportunities because I don't want to buy a distressed company because it's disappearing. I don't want to buy a Yellow Pages business that is being eaten by an online business. We don't want to buy a mall-based retail business that doesn't have a great reason to exist. You want to buy something that's in a cycle, that's going through something. What a microcycle means is the industry is going to come out of this. We are going to have telecom. We are going to have healthcare services. We are going to have housing. But there's something that has to be worked through. And might you get an opportunity to buy things with a higher margin of safety than you usually do?

29:13Because the market as a whole is saying, we're not sure how this is going to see through. People who can think about the asset side and the liability side restructuring and what companies are worth together get a chance to kick it through that micro cycle. We think it's the most important thing to think about when investing in distressed. Take me through housing, something you referred to a few times. Housing is a fun one because the U.S. has a large housing market, about 150 million units for a big country. And we've been frozen. We've been frozen in terms of transactions since interest rates started to go up.

29:47You might ask why the modern housing market is many ways 75 years old. We've been through ups and downs with interest rates before. Why did this interest rate move? Which, by the way, even though we've all been moaning about interest rates for a while, from realtors all the way to 1600 Pennsylvania Avenue, this isn't a historically high interest rate environment relative to other things. What you did have that was different this time, which is that in 2021 and 22, Americans were number one, obscenely rich. We became the greatest welfare state in the world pretty quickly. And the stock market did pretty well.

30:24And interest rates were essentially zero. Everyone in the country bought a house, moved or refinanced. So you have an environment where a very high percentage of mortgages were at historically low rates. You then have the inflation event and rates go up very quickly as people realize that transitory was a four-letter word. You move from a period of historically low rates to a period of historically high rates just after you had historically high activity in the mortgage market. And that means you're frozen. We go from five to five and a half million of existing home sales down to four. Where we were, by the way, in the financial crisis, which was a housing and solvency crisis.

31:08This freezing is a real impact on the dynamism of the country. One problem that Europe has as a monetary union compared to us is that if you are from Lisbon and get a great job in Stuttgart, you're not taking it. It's probably true the other way around. You're probably not moving from Stuttgart to Lisbon. It's culturally a totally different place to live, Portugal and Germany, even if it's part of a monetary union. In the US, part of what made us so dynamic is if you live in Columbus, Ohio and get an offer in Cincinnati, that's better you go. If you live in Las Vegas, you move to Orlando and America has been culturally homogenous enough to make it feel like I still live in America, I'll make new friends, we'll join a church or a country club and the public school and just roll.

31:50We've been frozen. We can't do it because you can't trade a 3 % mortgage for a 7 % mortgage. So what's happened? Existing home sales. going to 4 million from an average of between five and five and a half. We've dug into it. And it turns out that we think about half of those come from deaths, divorces, and homes that don't have mortgages. So we call those the deaths and divorces. We call them non-discretionary moves. Death is self-evident and divorces. Theoretically, you could live with your ex-spouse, but you might rather be dead. We think that the non-discretionary moves are about 3 million of the 4 million.

32:27which means we only have a million homes per year where people are saying, hey, I got a better job in Cincinnati. I'm taking it. Or, hey, things are going well. Let's get a better house. Or things aren't going well. Or the kids are gone. Let's downsize. That is not a sustainable thing. At the moment, population growth is low. So that helps. We also had a boom for a while in housing starts in places that were warm and may have lower taxes. But that is petering out as well. We see housing as this coiled spring. It has to come back. There has to be more dynamic movement in the housing market. You have vacancy rates that are historically at levels that you don't see for these periods of time.

33:14You see when rates have dipped for a little bit of time, you get extra activity right away. We think the housing market, which is everything from builders to realtors to the place we've been most interested, which is building products, which work for renovations. You've got lots of LBOs in the space, an enormous amount of debt, good companies. Every micro market is different. Some have two or three suppliers. Some have four or five. Understanding the distribution trains, understanding the liabilities. We see it as a cyclical micro cycle. Then I don't know when rates are going to come down. Everyone has been wrong calling rates coming down for most of the last three years.

33:49But when they do, you have a very interesting microcycle on the upside. And you've seen building products in particular, earnings expectations have really capitulated in 26, which could create interesting environment for outperformance. 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? 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.

34:28One 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.

35:10That'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 the other side, maybe they need a little more capital. Maybe they need a little relief, can get an earnings bonanza from the microcycle ending. We've seen that telecom has been the microcycle that we've prosecuted the most since COVID that's been incredibly profitable and with limited bankruptcies.

35:43It's been about finding companies at an inflection that are about to benefit from AI or are spending a lot of money laying fiber, but that will yield to higher penetration and market share over time, investing in those and then riding it out. We're going to take a quick break in the action to tell you about Ridgeline. Imagine starting your day with reconciliation already done. No spreadsheets, no breaks to chase, no duct tape holding systems together. Ridgeline is the first front-to-back system of record built for investment managers. One platform, one real-time data set, embedded AI. Investment firms are replacing a patchwork of isolated and dated order management systems, accounting systems, reporting add-ons, and client tools with this fundamentally new operating model.

36:33Automating complex workflows, scaling personalized client experiences, and unlocking the full value of AI. If this is the year your firm is ready to modernize operations and harness AI, you can learn more at ridgelineapps.com. And now, back to the show. When you talked about that analysis of ROI in is it a good business, it sounded a lot like someone who's underwriting the equity would look at, is this a good business? Is it gonna grow? How do you think about the difference between underwriting a business that's good and underwriting a credit senior in the capital structure at a good price? There's many ways to skin the cat.

37:17There are plenty of people who are more successful than we are who look at credit as a credit and say, I'm at the top of the capital structure, I'll be fine. Scott and I and the team think of ourselves as investors. There's something generational here. Distressed debt investing was such a frontier, say at least 25 years ago, even before the financial crisis, you didn't need to really care if it was a sock company or a steel company. You knew bankruptcy, the other guys didn't. That has been competed away and is competed away more every day. Technology helps level the playing field in terms of just going through docs and understanding process.

37:50The more deals we have, the more knowledge we have about what could happen and how we could get screwed. We start as investors. We start with, is it a good business? Will we invest in a business that we don't think is amazing because we think it's good enough where we are in the capital structure? Certainly. But if I look back at places where we've lost money and credit, do they line up in those types of situations more often than I would like? Yes. There are people who say, I only invest in great businesses. I only invest in monopoly businesses. That's not our business. We look at every new high yield deal, every levered loan, every direct lending.

38:23But starting with first principles of what makes a good business, debating that. I ask everyone I interview, what makes a good business? Why is it a good business? People struggle to talk about what it means. And we think it's, are you earning, if you're like an industrial, are you earning return on capital? If you're a financial firm, are you earning a really good return on equity such that not only are your assets secure, but you could trade in a multiple book? And in direct lending, where you can't trade, where you can't get out of it, we spend a lot of time saying, hey, do we think it's a good business?

38:55Do we think it has the right to earn a high return on capital such that it could handle all this leverage? If it goes through a recession or there's technological change, will it come out the other way? That's why we have a differentiated portfolio in direct lending because of that obsession with businesses. What are some of the other micro cycles you're excited about? 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.

39:27this 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 fascinating telecom is fixed wireless has taken over as a very important part of the broadband ecosystem. It was 150 % of the growth last year in broadband across the country.

40:02It'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 were just going around on 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 with tons of debt because it's supposed to be super stable. You're supposed to be able to just raise price every single quarter.

40:38No matter what you do, you call up and you beg, it doesn't matter. What we think is going to happen in telecom is more and more legacy, perhaps coaxial companies are going to be impacted by not only fixed wireless share, but fiber as it gets laid all over the country. And that fixed wireless is like a transitionary technology that eventually the large carriers will want to move those new subscribers to fiber that they've put all over the country and free up spectrum for AI and other things. We think we get another bite at the telecom microcycle as this transition happens away from legacy ways to connect to fixed wireless into fiber.

41:13There's many companies that are in the crosshairs. I think about things that aren't, that are developing now. Software is obviously, everyone's talking about its doom, but it hasn't developed yet. Places that we're looking at are chemicals. We take seriously the Chinese five-year plans. It seems very clear to us that China is focused on reducing the cost of base chemicals, ethylene and propylene. If you look at the amount of ethylene and propylene that they're bringing on and then go to 2030 and shut all of the European and Japanese capacity, in 2030, you'd have more overcapacity than you have now.

41:48On top of that, China is moving up the tech stack. So in chemicals, the holy grail is, are you especially chemical or not? And if you're especially chemical, you have a high margin, high multiple, and you're great. If you're base chemical, you're more cyclical. China's going up the tech stack. All of us have to take Chinese technology more seriously everywhere. I went to China in 2009 on an autos trip. I was an autos analyst. We went around to all the auto plants. And in almost all the auto plants, we saw usually a Toyota Camry, sometimes it was a Honda Accord that was being stripped down to literally copy what was being done.

42:24That colored my view on how to think about Chinese technology in autos. Fast forward to today, Chinese EVs, and you're saying, I thought we were talking about chemicals, But Chinese EVs are not only competing on cost, they're better. They're really good. People want them. They'd be all over the US if we weren't having geopolitical reasons not to allow them in. Just go to Europe, go to the Middle East. People are paying for them. This is the first instance where China is taking share, not just on cost, that they're taking share on cost and quality, technological know-how. They're quickly moving up the chain in chemicals.

43:01They want to be making specialty chemicals. They think they're going to have an advantage because they've also will obliterate margins in base chemicals. We don't think the chemicals industry is ready for it. There's going to be enormous upheaval in the global chemical market, even starting this year. We'll be really interested in playing that micro cycle as it goes through. What you describe in chemicals sounds like a short opportunity. I'm curious how you put that into the context of your portfolio. My father was an equity research analyst for many years. And I told him what I was going to do.

43:31I was going to go to the buy side and work at a hedge fund. This was a long time ago. He said, the buy side? Who goes to the buy side? He was shocked. Then he said, shorting is un-American. People don't like talking about shorting because in general, you want to be an optimist and you want to bet on things succeeding. But we do short. We short companies that are either frauds, that we think are frauds. Although I will say we call nine out of every two frauds. What we look in a portfolio is a company about to have a microcycle or less, right? That the way they make money, again, if you are obsessed with business quality and your analysts can say, how does this company make money?

44:13The second they see holes in that, then they're saying, wow, this is a problem. Is it changing? So we short companies that have very over-levered balance sheets or are over-levered relative to how they might perform. It tends not to be, oh, they're going to miss earnings, buy a penny. It's more like, are there fundamental changes? We tend to be positive on certain industries and negative on other industries. We don't try and match or we're not trying to be beta neutral or anything along those lines. What we're trying to do is find winners and losers as this kind of crazy global economy turns. In our hedge fund, shorting is a big part of what we do, but it's not a part of what we do in the other things.

44:53It informs it. Companies that we're short, industries that we're short, we don't touch them in direct lending. We don't touch them in the CLO. We run this business that's totally integrated where Scott and I sit in the middle of it. There are no walls and there are many firms that have all these products, but not integrated in the way that everyone is talking to each other all the time. We have a Zoom that's open 24-7. and we're popping in and out of it, it helps us have better risk management and hopefully better investments across everything we do. So the shorting is important, but I would never want to contradict my father.

45:27It's bad enough I went into the buy side. You mentioned healthcare earlier, the healthcare micro cycle. Where are you playing that? 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 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.

46:03Healthcare, 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 48 years we change what administration priorities are, Medicare Advantage is great, now Medicare Advantage is terrible.

46:35We 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 us. It's hard because you have to realize that we could be investing on the back of policy volatility and then get impacted by that same policy volatility. And so we tend to stay away from things that are single product or single payer. We like it if there's a mix of commercial, Medicare and Medicaid. We like larger businesses. We like return on capital.

47:09I once looked at a business in radiation oncology. The analysts are trying to think about what is going to be the government's payment for this product. I said, the government wants radiation oncology, but thinks it's being overused. If you're sitting in a government office and you are being reasonable, what is actually the return on capital that would make sense for them to provide? It was much lower than they were being paid. We look for businesses where we think not only is the current administration liking those elements of where they are, but what they earn today doesn't seem silly to us.

47:40It seems like a normal return on capital that would be supported by anybody. That's what we find. What the challenge in America for healthcare now is that healthcare costs are really rising again after a period of being less aggressive. If you think about elections, healthcare was the most important thing that we talked about in elections in 2000, 2004, 2008. And it really disappeared from our election rhetoric. Last year, you saw healthcare costs up across the board, commercial healthcare costs up 7.5%, employer payment for healthcare up 7%. The theme that could happen this year or the coming years is you see more people and more employers pushing that down onto employees, but in places where the cost is just getting out of hand.

48:26And the first place you're seeing it is with the ACA subsidies, the big debate over will they be extended? We're talking in late January, they haven't been extended. And that means that more Americans are going to be out of pocket for healthcare. Then if employers start saying to employees, you need to pay for parts of this, is inflation in healthcare going to suddenly impact how Americans spend for the first time in a while? It matters. There's a great study that Australia Australia, their Medicare system, which is universal health care, they did an experiment where they said if people just have to pay one or two dollars for prescriptions, what does it do to utilization?

49:01It really impacted demand. We think you could start seeing inflation impact consumer choices in health care for the first time in a while. And there's not every business model set up for that. 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? 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, myself very much included.

49:46There 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.

50:29It's contract. What does the contract let you do? Okay. There were norms that existed for a long time not to take advantage of those things. What's interesting is creditors, we've long been willing to beat the living daylights out of each other. It's a part of finance that isn't necessarily the most glamorous and fighting is part of it. The norms held it together in the sense that there was just so much you could do. People wouldn't be willing to use loopholes in documents that were clearly there, but were designed for a different purpose. Those norms have really disappeared for good reason. Not only does capitalism require it to some degree, but I think also that a lot of levered deals got into trouble over the last few years, not because the owner, the sponsor, whoever it was, made a terrible underwriting mistake.

51:17That's usually what happened. It's because inflation came in a way that wasn't expecting. If you think about what corporates have gone through in the last few years, one of our themes is the resiliency of the economy. In the financial crisis, auto companies went from selling 16 million cars to 15 million cars, and they were all immediately insolvent. Today, we had a pandemic that shut all production of everything. Then you went into inflation. You got the war in Ukraine. The Suez Canal is basically closed. And companies run from one thing to the next. They're resilient and they can handle it. owners of companies said, look, inflation was worse than we thought.

51:51We don't want to lose the business over that. What basket can we use? There's been an approach to allowing creditors to fight more naturally with each other. That's happened over the last few years. It's gotten a lot of headlines. It's made it harder to invest in distressed businesses because what we do is we say this business was once great. We think it could come back to being maybe good. Where should we buy the debt, if it was worth a billion once, and if we can buy the debt for 500 million, do we think it's definitely worth 500 million? You might say yes. But if you say, aha, you may think it's worth 500, but it could be that when you buy the debt, in reality, there's 750 that's going to go ahead of you.

52:32Really, you're buying it more expensive than it was before the world changed. I don't want to invest in that at all. So it's made it much harder to invest. I think everyone's acting rationally and responsibly. The world is turning. And one thing you're seeing is co-ops, which are cooperative agreements between creditors to say, we're not going to do a deal with the company alone. Neither should you. Have really come into vogue over the last 18 months. There's fighting back against that now. There's publicized litigation against it. I think it's just a living organism. What cooperatives allow you to do is say to the company, we as creditors will give you a capital solution, not one individual creditor to screw other creditors.

53:11You're seeing that now in bigger situations. Smaller situations remain an enormous wild west. 18 months ago, I was pretty down on distressed in the sense that I thought it would get worse and worse than your ability to invest. As the world turns and cooperative agreements and finding sponsors that are amazing to work with, that love their businesses, want to keep them and want to find capital solutions for it, I'm more optimistic that it's not going to be bloodying each other, but it's investing. 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?

53:52We 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 a 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.

54:30We 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$250 million we need to fix the business.

55:09One of the people said, diameter's in this, they're small, we want to call diameter, we want to get them involved. We ended up doing something different and we got a great M &A outcome and no one knows how terrible it could have been. That's really worth something to me. That was a firm that we do a lot of business with and we all know the ethos. We're not going to hurt ourselves in situations to bend over backwards to make sure nobody ever loses money. That's not our responsibility. But if you're a repeat player, then the market treats you differently than if you're a one-time player. What I've learned from restructurings now is you need to give everyone time to pound their chest.

55:43I remember the first restructuring I worked on in great detail, the Lear restructuring. It was so clear to me how it should go. I had my model. I had my spreadsheet. It was so clear to me. We sit in the room with bank debt lenders and the company and the revolver and the unsecure bonds and everyone's yelling at each other. I turned to my colleague at the time, Charles Tauber, who's now at PJT. He was older than me then and older than me now. I said, this is crazy. Let's just tell the quid like the largest secure, the largest unsecure. And he said, you need time to pound their chest. Everyone needs time to scream and yell, and then we will get something together.

56:24To some degree, you want to allow that to happen. In distress, it's part of the process. Being a repeat player helps, but you have to make sure you're well positioned because at the end of the day, people will be economic animals. One of the other big trends in the credit world is the growth of IG from insurance companies and the demand for that paper. I would love to get your perspective on what's happening there and And how it may or may not impact you in what you see the credits you're looking at. We do a lot of IG. We are very involved in IG New Issue and IG Trading and IG Investing. We never want to be a tourist in anything.

57:03IG is sometimes interesting for our hedge fund, sometimes less interesting. Unless we were native to it and had every day in that market, we would be a tourist. And you never want to be a tourist. The best explanation I give is I was once around COVID time traveling internationally, seeing a client, and they still required a COVID test. So the night before, we're like, what are we going to do? My colleague from IR, Ryan and I, we spent$450 each for a COVID test in the hotel. The next morning, we drive up to the client, negative, free COVID test in the lobby. Tourist. IG is a very important part of what we do in structured credit and in corporate credit.

57:40What you're referring to is the explosion in IG-type capital solutions, really driven by insurance. and we're very active there too. I would say the private IG market has been a great place to invest because we've been investing in companies of consequence with really good structures to earn a little more. The earning a little more is the answer. If you think about the insurance business or the annuities business, it's taken off over the last few years for good reason. As rates have been higher and as Americans have aged, annuity products make a lot of sense. An annuity is a long duration liability that you get premiums in for that you have to invest over time.

58:23The way you invest is highly regulated. You can't buy crazy products. You have to do it in a very conservative way. If you are an insurer like this, the holy grail to you is a non-risky asset, an IG or IG-like asset that yields a little bit more than what invests in grade. Investing grade is very tight at the moment. You're able to say to the world, hey, I can take illiquidity. So I have many years. I can match my asset durations with my liabilities. And what has emerged is insurance solutions business that provides these type of assets to insurers that oftentimes will give 50, 75, 100, 200 base points of extra spread.

59:03It's a great business. We are involved in it. We're doing a decent amount of asset-backed finance. We want to do more. It's a responsible way that Wall Street is providing solutions that work for people. But there is a danger to it you're alluding to, which is when you're creating lots of tranche structures, the thing that we all remember is during the financial crisis when people wanted triple new, triple A. So they took triple B RMBS, combined it into a structure to create a triple A CDO square that was entirely composed of something that ended up being worth nothing. Then your rating was a helmet in a skydiving accident.

59:38Like it didn't really matter. The analogy we used in our last letter is the great Seinfeld episode with top of the muffin to you, which were two characters trying to create a store just to sell the top of the muffin. It didn't work because when you just baked the top of the muffin, it didn't taste like a popped off top of the muffin. It didn't have the structure and the texture. Then I think it was Elaine and Mr. Lippman, they decided to bake the whole muffin, pop the top, and then they needed something to do with the stumps. The garbage dump wouldn't take it because it's food, not garbage. I think they donated it to a homeless shelter and the person running it came and screamed at them that it was inhumane to give this to the homeless.

1:00:17They want the tops too. They don't want the stumps. They ended up closing. It failed because they had nothing to do with the stumps. One thing we're seeing is we really love the IG market. We love creating these assets for insurers, investing in them when they make sense for our funds. But some insurance solutions involve creating a muffin top and a stump. Because if you create a muffin top, you are creating structural seniority that makes for less risk. It makes a lot of sense and the insurer's balance sheet makes a lot of sense. What do you do with the stump? We've spent a lot of time trying to look at the stumps.

1:00:51The stumps often are residuals that don't generate any cash in the near term, but offer a nice kind of mid-teens return. We think that Wall Street is getting a little short on places to stick the stumps. They're coming up in special situations funds. They're coming up in interval funds. They're coming up in places that people may not appreciate what happens when you're not getting cash for a long period of time. This is technical, but CLO equity, which is a highly levered asset, is an amazing asset class. Because when anyone models a CLO, they say there will be a recession sometime in the next 18 months.

1:01:23I had an old boss who told me that if anything is coming in 18 months or the back half of the year, it means no one has any clue. But you model a recession every 18 months. What happens when CLOs, you might get that recession to end all recessions, and that will be bad for the assets, the levered loans. But you take cash off the table right away if you were the equity. That helps pay down your basis right away. While we love this IG-like insurance solutions market, we're worried about the stumps and where they're going. If you're going to invest in ABF, you need to invest in people who are underwriting the whole thing correctly, who are thinking about, do we want stumps?

1:01:58If we want stumps, how are we underwriting them? And do we have enough milk to get them down, so to speak? If that risk you're identifying were to play out, what might that look like in that ecosystem? 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.

1:02:40All 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 doing. 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 08 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.

1:03:14The 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 your special situations funds, not that the global economy comes down. As you think about the systemic risks alongside of your identification and diving into microcycles, I'm curious how you incorporate what matters in the macro landscape into what you're doing. We're obsessed with macro. We think you can't outsource your macro. The team has to be on the same macro footing.

1:03:52If someone comes and says, I want to make an investment in a retailer or building products company or an industrial company, the first question is, what GDP assumption are we using? What inflation assumption are we using? Are we making a economy bet, a market share bet? We're not economists, but during COVID, we were pretending to be epidemiologists. It wasn't that we were saying, oh, wow, this is going to happen. It was, hey, we need to understand ourselves what the outlines of the potential spread could be. Every single morning, I would wake up, analyze the data on COVID, and send a note to the whole team that turned into kind of my pet COVID blog project.

1:04:28We do the same with macro. Scott and I really believe in making the sausage. Scott does an enormous number of our traits. I do our macro. When CPI comes out, when the jobs report comes out, I go into it. I have my own models. I create my own charts and most of the charts I create don't show me something. And so integrating that and constantly being in the numbers, in the data, I don't want to be someone who's receiving a PDF or a deck and just reading it. I want to see how it's made, how it goes through. Understanding it has allowed us to have theories on the economy. We think that the consumer being under levered has been part of an income cycle, higher wages, higher spending, higher inflation that will of course one day break, but doesn't abruptly stop.

1:05:11It doesn't just stop immediately because it doesn't have a lot of debt and because wages have been growing. Therefore, we can see through these scares when everyone screams recession from the rooftops every six months because consumer spending dipped a little that much. We incorporate it in everything we do. The analysts all incorporate it in their modeling and in their industries. They then give it back to us. This is what we're seeing. Last year, we saw packaging really get hit. What's interesting is packaging is an industry that's supposed to be super stable. And now it's widened significantly from the index to almost be stressed.

1:05:46We said, is this a slowdown in the consumer? One of our analysts thought it was. Then we said, wait a minute. How is it that you can't get a concert ticket or an airline seat? Cruises are doing fine, but packaging is suffering. It made us realize that part of the elements of the, I guess, the K-shaped economy that people refer to, which I don't love as an analogy, we're playing through that packaging is one of the places that is even or more even across the economy. Whereas in places like durables and services, the top 25 % are responsible for say 50 % of the spending. But that also something else was going on that it couldn't just be the economy that was explaining it because you actually had an incredible GDP for personal consumption.

1:06:26It's that GLP ones were impacting grocery, that changes in alcohol, we're changing spirits buying. And that we think a mystery that's happening that really can't totally get my head around, and that's why we haven't made a lot of recent investments in packaging, is it seems that Americans are using less, right? Buying less food, even with not on GLP-1s. I have theories, maybe people were so oversupplied with this stuff after COVID, and then those things got hit by inflation, that they're learning to use it less. So the macro informs everything we do and we don't make macro trades. It said it informs us.

1:07:01It gives us a big advantage over others that wait and see what the bank's economists will say and then maybe or maybe not incorporates it. Also, our models have to be the same. If we have two different analysts with different macro inputs, one for autos and one for housing, then what are we doing in terms of thinking about what's better, housing or autos? It's something Scott and I take seriously and that we also enjoy. How do you think about your positioning in a world where there's this surge of very large credit players and you have scale and there's another side that's probably much too small to compete in this world?

1:07:38We manage upwards of$25 billion. I was at a credit conference for Apollo last year, and I think on the stage it said they manage$450 billion, Right. Our mothers are very proud of me and Scott and the whole team, but we're a pipsqueak compared to them. This question is overhyped because it's an important question as investors try to figure out, are you going to lose your edge? That's the hardest thing to do. Figure out if the past is going to be the future, whether it's a stock or a bond, or if a GP who's been good is going to continue to be good. For us, it's all about, do we have a flywheel that works?

1:08:14even when we just had a hedge fund, we've always done two things. Tried to find cheap bonds or loans or overvalued bonds and provided capital solutions. We originally did it through the syndicated market only. Now we do it through the direct lending market and capital solutions. And are you of a scale that you can continue to be relevant? And so direct lending, we didn't think we would have eight years ago when we started because it didn't complement the syndicated market. Today, it's crucial to have direct lending because sponsors and others want both. They want a syndicated solution, a direct solution.

1:08:52You have to be able to look at both. We don't do relative value, but when we're looking at something in direct lending and it's only, say, S plus 475 and there's something similar at S 400 in the syndicated market, we're going to say, maybe you're not getting enough for the illiquidity. I don't think the absolute size matters. What matters is in the markets that you're in, are you relevant? One of our favorite examples was December 26th. And Scott was on the desk. He got a call from a sponsor that said, we're trying to return money to our LPs this year. That's been a big theme in private equity.

1:09:28One situation that we were banking on is it didn't come through. There's another portfolio company that we would like to do a dividend for. We know that you guys own the syndicated debt in your CLOs and also own the bonds in your hedge fund. You must know this company very well. Would you do a juicy direct loan dividend deal between now and December 31st? We said, of course. That means there are many bigger hedge funds. There are bigger CLOs. There are bigger direct lending businesses. The question is, are you relevant to get the best deals that you want to put together your portfolios? And we are.

1:10:01The Supreme Court says pornography, you know it when you see it. That's also true with being too big. So we've purposely capped our funds. Our hedge fund has been hard closed, returned capital on two occasions. We capped the size of our most recent dislocation fund because we don't want to be in the situation where we get too big and we can't actually invest. That's the constant trade-off. I understand why the question is asked, but it's all about that relevancy flywheel in what you're doing as opposed to the absolute size. I want to make sure I get a chance to ask a couple of fun closing questions.

1:10:34Before we get to the closing questions, I want to tell you about one of our strategic investments. We've made a few, and each are working on a product or service we think will be valuable to our community. One is Ascension Data. Ascension provides workflow software for compensation that allows you to track, plan, and take care of your team. We're excited for you to check out how they can help solve the sticky pain point of compensation. There's a link in the show notes so you can learn more. And here are those closing questions. What is your favorite hobby or activity outside of work and family?

1:11:09The last time I was on, I had prepared the answer. And I think I talked about running and I've thought about it since. I wish I could tell you that I have this great hobby where I build ships in glass bottles or I whittle wood. But the truth of the matter is I don't really have hobbies in the sense of really perfecting something to be good at it outside of work. I like to ski. I like to run. I like to read. I don't have hobbies in this traditional way because I do what I like and it makes me boring, but I like reading about the news and reading about the world. So I regret going with running last time and I hope I have write at the record that I am the hobbyless man.

1:11:56What was your first paid job and what'd you learn from it? 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 what your seniority level is. And it's government, so who gets a driver and who doesn't.

1:12:36I 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. I was 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 and we 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.

1:13:12We'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, but that's what I learned from it. What's your biggest pet peeve? We spend a lot of time on Zooms at Diamma, both internally and externally. I don't see why the norm has become that turning on your screen is optional. The whole purpose of the Zoom is that we can have a more intimate discussion looking at each other and seeing facial expressions than we can over the phone. At Diameter, we have a rule that your video has to be on at all times.

1:13:52We do it externally also. It's a real pet peeve when people are sitting in an office with the screen off. We know that you can be looking at the screen and not focused on your work, but at least creating that illusion makes for better calls. So the screen off in Zoom is my pet peeve. What's a mystery you wonder about? I think the next two years are giving us so many known unknowns that I can't really wrap my head around it. Today, just sitting here with AI, not even really ready for primetime, and you have very high, I think almost 9 % unemployment from college grads. What's going to happen if that goes to 20 %?

1:14:30We're going to have an election, maybe as that is coming around prime time. Figuring out what's fake or not is impossible. The mystery to me is we've had this great experiment with representative democracy where we send people on and most of us then just do work for two years or four years. We lift our heads up. We say, hey, were you good? Were you bad? Vote you in, vote you out. Representative democracy really only works if you have accountability. Say, hey, this person was terrible. And you pull them back. When Jimmy Carter was voted out of office after 2008, the Iraq war, the American people said, no, this is not working.

1:15:06You can't have accountability without some shared set of facts. Half the country thinks that the January 6th people were traitors. Half the country thinks they were patriots. The mystery to me is how our system is going to see through this. Forget about any particular politician. The mystery is the system working with A. How did it work retraining all the steelworkers for internet technology jobs? It failed because it's impossible in a democracy. You can't say, quit your job now. We're going to teach you something else to be an internet salesperson. It doesn't work. Transitions when we're already in this period of nothing is real and everything is fake is a mystery that I am not certain we'll be able to see through, as optimistic as I would like to be.

1:15:47I've made a life and a career out of being an optimistic person. All right, John, last one. If the next five years or a chapter in your life? What's that chapter about? Scott and I still think of ourselves as very young. This is the part of the year that we're the exact same age, we're both 46. The question feels alarming to me. I was talking to someone who was president of an old homeowners association. And I said to her, what's your goals in your presidency? She said, keep everything the same. We don't have that luxury though. And what's really important to me and to Scott is to be able to make the sausage.

1:16:19And the technology is changing so quickly that you have to stay on top of things. What worries me and what I'm focused on, what I see the next five years being for me personally and for Diameter is all of us learning how to use this technology, not being left behind by this technology. If they outsource the managing partner of an investment firm, I'm screwed because I want to do this for a long time. And so learning the skills to continue to compete at this level five years from now is what this is about. This is an epic of extraordinary technological change. I hope we can wake up in five years and I can say, and Scott can say, and our team can say, we are at the forefront of using this technology to produce alpha for LPs.

1:17:04We'll see. But that's what I hope the five years are about. John, this is so much fun. Let's make sure it's not another five years before we do this again. Thank you for this opportunity. You have an incredible network here. What I think is cool is I listen to this podcast all the time, so I will have to skip the episode where I'm in. It's humbling to be on with so many of the great investors and allocators and others that you've had on. Thank you. 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.

1:17:37Have 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. This 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.