Macro Challenges and Credit Opportunities: Davidson Kempner’s Tony Yoseloff

0:04Welcome to another episode of Goldman Sachs exchanges, great investors. I'm Tony Pascarello, Global Head of Hedge Fund Coverage in Goldman Sachs' Global Banking and Markets Division. Today, I have the pleasure of speaking with Tony Yosiloff, the Managing Partner and Chief Investment Officer of Davidson Kempner Capital Management. Davidson Kempner is a hedge fund with approximately$37 billion in assets under management. Tony joined Davidson Kempner in 1999 and has helped navigate the firm through market cycles along the way. While Davidson Kempner has many different strategies, the firm is known for its focus on opportunistic credit and event-driven investing.

0:44We're going to talk about this current market moment, the keys to being a successful credit investor, and where he believes the opportunities are in the alternative investing landscape today. Tony, welcome to Great Investors. So let's start with a quick level set on Davidson Kempner. What's the history? What's the heritage of the firm? So Davidson Kempner actually started out as Marvin Davidson's family office. Marvin Davidson was a senior executive at Bear Stearns in the 1970s. He left in 1981. And his goal was basically to be able to manage his own money in a way that was non-correlated to the overall markets, but to still be able to generate strong returns.

1:24So he started literally in his townhouse. So this was in the basement floor of a townhouse on the Upper East Side. Give me a year. When was this? So 1983 is when the firm started. Tom Kepner joined him a couple of years later. And the idea was to basically pair investing in opportunistic credit situations, which was Tom's expertise from his time at Goldman Sachs, to investing in different arbitrage situations, particularly risk arbitrage, because that would have been big in that era. And those were some of the areas that Marvin ran at Bear Stearns. Fast forward to 1987, Tom approached Marvin, said, hey, I think we've got a good thing going here.

1:59Maybe we can take in some outside money. So Marvin said, well, I don't want to spend my time on this. but sure, if you want to do it, let's go for it. And they cobbled together$20 million of friends and family money, which was actually a lot of money in 1987, and really started to grow with the industry. That was the early days of Yale and the Swenson model. And the term absolute return was invented in that period of time. I joined the firm in 1998, at which point we're about a billion dollars under management and probably up to 15 people at that point, which would have been a larger institution.

2:30And we've continued to grow with that. But the origins of our firm And the Hallmark are still very much in the family office days and managing money for Marvin and his colleagues. And what would you say makes the firm unique? Well, it's interesting. If you start from what we've become, and again, the origins of Davidson Kempner was we would have been one of the early absolute return firms. I do think we have a fairly unique mixture of public equity strategies, public debt strategies, and private debt strategies all rolled into one institution. You certainly have institutions that have each of those individually of a size and scale that are equal to or greater than ours, but you don't have that many folks who bring them all together.

3:09In our absolute return-related strategies, we think it's important to have a healthy combination of both debt and equity-related strategies and really to be global in how we invest. About 40 % of our investments are outside the United States. So, for example, if M &A is very attractive or risk arbitrage is very attractive, we'll scale up in that strategy. strategy. If credit strategies are very attractive, and that might be in the US, it might be overseas, it might be structured products versus being core corporate debt or special situations, we'll scale up in that strategy as well. But it's very interesting to have this combination of both private market and public market investments in one place.

3:47I mean, the very large alternative asset managers tend to skew more towards private strategies, but don't necessarily have the same breadth and depth of public strategies that we have. And I think that you learn a lot from both markets. The markets move at different paces in bad times, so crisis times, COVID or GFC or whatever. The public markets move a lot more quickly and a lot more steeply. And then the private markets follow. But often their cycle takes a lot longer to materialize than the public market cycle does. So we learn a lot about our private investments from what we see in the public markets.

4:18And conversely, we learn a lot about our public investments from what we see in the private markets. And again, having this mindset where you can go back and forth between credit and equity, also very powerful. Let's drill into the markets today, the setup today. What are you and your partners most focused on? You know, there's a few things that are really of interest in our areas of opportunistic credit and event-driven investing, which are really the areas that we focus on. So I'll talk about a few big themes. The first theme I want to talk about is interest rates. And I know the excitement, if you read the newspaper in 2025, is the fact that we're likely to have lower base rates in the United States.

4:54It's all been telegraphed by the administration in terms of where things are likely heading, and the Fed seems to be starting to move along. To me, the bigger interest rate story that we're still unlocking is the dramatic move up in base rates in 2022 and 2023, when you had a 550 basis point plus or minus move in base rates in an unprecedented 16-month period of time. So what that means from my perspective is you still have a lot of capital structures that are out there. Some of these are corporate capital structures. Some of these are real estate related capital structures. Some of these might be in other sorts of vehicles that don't make sense based upon where rates are today, or even where rates might be going towards because they were never built for normalized interest rates.

5:38And if you look at a base rate of around 4 % today, that is a normalized interest rate. The 100 year history of the 10-year in the U.S. is between 4 % and 5 % in terms of where rates are. And so as those come home to roost, right, companies can defer interest payments, but they often have to meet maturities when they actually come and do. There's still a tremendous amount of restructurings that are going on underneath the hood. In public markets, those are often called liability management exercises. And in private markets, those are involuntary pick, or there's different terms, payment in kind, i.e.

6:09people not paying interest when they're supposed to be paying interest. And so I don't know if we're going to repeat the history of the 1970s, but we're certainly going to test it. The history of the 1970s is that we cut rates too soon multiple times and each rate rise was steeper than the prior rate rise. So we're going to test that thesis over the next couple of years, I suspect, and either it will be the right answer or it won't be the right answer. But if it's the wrong answer and you have all these capital structures that don't make sense already, and then you put gasoline on that fire where we'll see where things are going.

6:38So that's an area that's of real interest to us. The second area of interest to us is investing across the spectrum globally versus the US. I think there's just a tremendous amount of focus on US markets. And there's good reason for that. US markets are what, 70 plus percent of the global equity market cap sits in the US. We are global investors. About 40 % of our investments at any period of time sit outside the United States. The investing climate, the investing stories outside the United States look dramatically different than what stories look like in the United States. So for example, Asia, right?

7:12You had slow economies in Asia for a few years. India has probably been the bright spot there. There's been a lot for us to do from a lending perspective in India. I would say there's a reasonable amount of equity capital chasing opportunities in India. There's still a relatively small amount of credit capital chasing opportunities in India relative to the market set. This is growth capital. These are promoters who are happy to sign up for very substantial rates of return compared to what you would get for similar credit in the U.S. for a couple of years because their equity cost of capital is actually quite a bit higher than that.

7:42Europe is another one. We've been quite busy in Europe in both our credit business and our equities business. Europe is a slow growth economy. There's also been a real shift where the countries in Southern Europe, which historically have been the laggards, have actually been the leaders in terms of growth. Many investors are afraid to invest in those countries, I think in large part because of historic results. We've always been willing to invest throughout Western Europe. We're not limited to the Northern countries in terms of where we invest. The country by country nature in terms of how things are set up in Europe and the relatively slow to move regulatory environment are certainly factors that always make Europe from an opportunistic credit or event-driven investing perspective interesting places.

8:23Just look at where dollars are, right? So I think like close to 75 % of the leveraged credit dollars in the U.S. come from investors. It's more like 37 % in Europe come from investors and the rest come from banks. And so there's just tremendous opportunity in a market like that. And then the third thing I'm really focused on, because I think it has impacts across businesses, but it would have an impact on our business, is the M &A cycle as well. After four, quite frankly, really slow years during the Biden administration and a lead into that during COVID, where you basically had every buyer have a free shot on goal on undoing their agreements in 2020 because COVID wasn't accounted for in the legal terms of those agreements.

9:03So it was sort of a Mac in most cases. It seems like the starter gun has gone off in terms of M &A. I'm sure the bankers in this building are very active with it. But no, the third quarter, I think, was the second busiest quarter in the last 10 years for M &A. And it was pretty close to the quarter in 2015 that would have been the top period of time. You're seeing transactions that are getting announced that people maybe wouldn't have dreamed of. Number twos buying number threes in heavily consolidated industries or railroad consolidation, where you really only have four major players in the US.

9:35And we think you're going to see a lot more of that. First of all, I think there's an openness in the Trump administration to doing large deals, probably with remedies attached to them as opposed to just straight approvals. I do believe that people are going to continue to abide by the antitrust rules of the United States. But if there's an openness to doing things, I think boards are going to take a try. And my experience with M &A is if there's M &A in your sector and you don't participate in it, there's a lot of FOMO in that world and you ultimately want to participate. And it's not really just FOMO, it's fear of getting left out and fear of being in a non-competitive situation when you were a competitive situation before.

10:11So the administration has only been in place for nine months, plus or minus. And so there's still a lot of room to run in the next three years. Whether that will have legs as much to Europe or Asia, I think is still to be determined. But I think there's a lot of excitement in that world, too. And so a busy M &A environment will have an impact, I think, throughout markets because all of a sudden there's a real strategic bid for assets. It's not just a financial bid. So those are kind of the themes that we're particularly spending a lot of time on at DK. Let's talk about the business cycle. Each investor is going to have their own way of thinking about the business cycle.

10:44And in a way, you've referenced a couple of different ones already. In a way, COVID, the COVID era each year has unto itself almost been its own business cycle, I think 2020 versus 2022. I'm curious, when you walk in the office every day, how much of your process is trying to assess the cycle? And I think what I'm trying to get at is how much is a top down versus a bottom up process? Well, as it's starting out, I think for 2025 alone, you can just get lost in the headlines, right? I mean, a tremendous amount has happened in this year, whether it's the move in markets post-liberation day or some of the geopolitical conflicts we have out there.

11:19But if I think about how we actually invest at Davidson Kempner, as a starting point, we are micro investors, right? So we are trying to isolate events in our event-driven mantra or an opportunistic credit. We are trying to either loan to or create assets with a really large margin of safety on it. So So even if bad things happen in markets, we can at the very least get our principal back. One of the investing lessons I learned during the global financial crisis, which I kept, is if you have a macro viewpoint that's strong and your micro investments conflict with your macro viewpoint, you need to understand why.

11:57So I'm not a believer in the fact that you should avoid a micro investment because it happens to conflict with your macro viewpoint. What if your macro viewpoint is wrong, as an example? And I think the probability of getting your macro viewpoint wrong is higher than the probability of getting your micro viewpoint wrong. On the other hand, if there's a massive opposition between those two factors and you lose money, you probably should look at yourself and say, hey, why was I in this in the first place if I had this macro viewpoint? So I do look at things today. We obviously spoke about the interest rate concerns I have.

12:29I would say a second set of concerns I would have just general is we haven't had a real recession outside for a few months in COVID since the GFC. I mean, there's a short period of time in the early 2010s that you might refer to as like a softening, but it really wasn't technically a recession. There was a COVID recession for three or four months the way it played out. That's a really long time in markets. And we could spend the whole podcast talking about valuation excesses or things along those lines. And so you are seeing a lot of late cycle behavior out there. And when that ends, who knows?

13:00But I just think you need to be prepared for it. And let's just spend a minute on that. There's been a lot of talk in the market recently. We've published on this. It's kind of a question of, are we in a bubble or are we not in a bubble? Do you have a view on that? So the answer is, I don't know, but I'm quite concerned about it. So let me explain why. So I'd start out with a basic thesis. And by the way, you could have said this three years ago, pre the AI trade, let's say, but it's only gotten worse since the AI trade. And this is that 40 % of the S &P is in 10 stocks, plus or minus. So if you go back and you look at historic levels of concentration in that index over the last 60 years, you only see two periods of time that are close to that.

13:41One of them is the early 1970s. That's the 1972 to 1973 era, which would have been the era of what was called the nifty 50, which would have been the greatest growth stocks of that era. And the second era, which is around when I started my career at Davidson Kepner, would have been the 1998 to 2000 period of time, which I'll call today internet bubble 1.0. And so if you look at what happened in those periods of time, right, the nifty 50, the theory was you had these great growth stocks and they were going to carry the day. And the theory of internet bubble 1.0 is the internet is a transformative technology and that ultimately is going to carry the day.

14:17So both those trends were right. But if you actually look at what happened, it took you 15 years from the peak of Nifty 50 to get your money back in terms of where things were. So you sat on dead capital for 15 years. And the reason you got your money back was stocks like Johnson & Johnson and Walmart in particular rode out versus all the companies like Kmart or Kodak or whatever that you forgot about that would have been part of that. It was very similar in the early 2000s, right? If you bought the NASDAQ at the peak of 2000, I think it was like March or April 2000. Yeah. It took you to the mid 2010s to get your money back.

14:51And again, it was a handful of stocks like Amazon or Apple that really carried you through and a lot of carnage along the way. So it turns out 15 years to get your money back is a really long period of time, even if you were to look at both indices today and you feel quite good about where things are. And so from my perspective, the question is, you have all this CapEx that's pouring into AI related investments. What you hear out there, which is true, is that the great majority of that CapEx is coming from some of the healthiest companies on the planet that are taking their free cash flow and they're investing that money into AI.

15:26So it doesn't really matter, quote unquote, how long it takes to get your money back. Well, The stats I would throw out there are it took about 10 years from when personal computers became popularized in the United States in the 1980s to see productivity gains in the workplace from them. And so that's a very long time to invest a huge amount of CapEx to get the benefits from it. It was probably like five or six years from when the internet really became mass marketed in the early 1990s to see productivity gains. Those productivity claims came in the 1990s and early 2000s, and they flatlined for a while after that.

16:01So the way I like to think about it is, is there going to be an AI wobble at some point? Are investors going to be concerned about how those CapEx dollars are being invested? And right now, there's a little bit of a prisoner's dilemma, let's call it, among the larger firms. You have to invest in it because your peers are investing in it. And so if you're left behind, you're not going to have the stronger competitive position to it. But what happens when the market starts to challenge the assumptions of just what the returns are going to be on this and, you know, how patient is the market going to be on those returns?

16:31You know, I mentioned the concentration that you had three years ago in these MAG7 type stocks. That was pre-AI, right, in terms of where things were. And so my concern and thought process is that these stocks are just so dominant in the overall investing, even if they're not a big part of your investing platform, that they're going to have some sort of impact on you. And then there's all the secondary companies that are out there, whether it's power production companies or other companies, chip companies that have second year companies that have impacts of this, right? If you look at how some of those stocks got hit during April, right?

17:04And the sell-off, it was very hard, right? It was very hard, very quick. And so we're quite concerned about it, even though it's not really day-to-day what we're investing in, but I think that will impact, we'll have opportunities. I will say that the early 2000s were a fantastic time for absolute return investing. There was a tremendous amount of dispersion in markets. There's a tremendous amount of dispersion in markets today, both in credit markets and in equity markets, whether it's event-driven strategies or relative value, absolute return strategies. The early 1970s, the financial markets weren't as formed as they were today.

17:38I think, unfortunately, in those markets, you could have hidden in gold or you could have hidden in oil, but there probably weren't that many other places to hide in those markets. And part of that was just the dramatically steep rise that you had at interest rates. And even though I do think there's some risk of that in the US, I don't think it's anything like what it what is the 1970s. So I want to talk about private capital and private credit. I think you all got involved in that space circa 2010. A lot's happened since then. A lot has happened just in the past four or five years. Where do you think we stand today?

18:08Has that all gone a little bit too far or not necessarily? It's probably a little bit of both. So my truisms of investing are that capital chases returns and that markets become efficient over time, right? So if you go back again to the Swenson model or the Ivy League model, Yale model, whatever you want to call it, for investing, there's a belief that private markets are always going to outperform public markets, so you should invest heavily in them. I don't share that viewpoint. I share the viewpoint that private markets should outperform public markets because they're less efficient and they take more work to unlock the value.

18:42But fundamentally, all markets behave in the short term based upon supply-demand dynamics, and those supply-demand dynamics can even out over time in some markets can become more heavily invested. And so, as you mentioned, we started investing in private capital markets through drawdown funds in the 2010, 2011 timeframe. I did it simplistically because you could no longer make some of the investments in absolute return strategies post global financial crisis that you were able to make pre-global financial crisis. And I thought there were going to be really interesting opportunities in providing debt, purchasing secondary debt and taking control of assets through special situations.

19:20And that story has really played out. If you were to look at the growth of the overall industry, absolute return strategies and private capital strategies away from AR, so this could be direct corporate lending or it could be private equity or it could be growth equity and venture capital. The AUM of those areas was about the same size going into the global financial crisis, but post-global financial crisis, almost all of the growth has come from the private capital portion of things. And the most recent flag of that has really been retail in terms of getting into those markets. And I would say a lot of the retail products that are offered are not exactly what you would get.

19:55Institutional products, some are, but not all of them are. So I just think you have to go back to the basic supply-demand dynamics of it. Like, I think the area is tremendously interesting. I think it's over outside the United States, still in its infancy compared to what it is in the United States. But you look at areas within the United States, and I put growth equity into this area where it's highly competitive, highly picked over. very well known, very interesting to a large group of investors for a long period of time. And I go back to capital chases returns and markets become efficient over time.

20:24And so whatever you expect beta efficient returns to be, that just might be what you earn in that asset class. I don't think that's true for all parts of private credit. The areas that have had less growth in them are far more inefficient than the areas that have had more growth in them. And I think those were areas that will likely do better over time. So I do think that the industry in general is going to continue to grow. but you just have to be aware of the amount of capital chasing any particular opportunity. I want to ask a couple of questions about your career and how you got started in money management, but was there anything on the markets that you want to register that I didn't get to already?

20:59We spoke about this, but I just want to highlight it. It is amazing how much happens in any given year. And there's a lot that you can paint into that. You can paint into that political administrations. You can paint into it a viewpoint that I have that perhaps we're going through a period of deglobalization, right? If the 2000s and the 2010s were a period of globalization, perhaps the 2020s are a period of deglobalization. You can talk about it, about a period of mass technological change, right? So the AI conversation that we're having, we wouldn't have had three years ago, right? Or you can just say the amount of information we're creating in the world today is a multiple of what we were creating 10 years ago, which was a huge multiple we were creating 30 years ago.

21:43And maybe that's why things go faster. So as you think back to these early 1970s periods with fixed commissions and three martini lunches or whatever people did back in that era, obviously you and I weren't around for it. You know, maybe just things move faster today than they moved in that period of time. It's probably all of the above, but it makes for a very dynamic and exciting market. But it's not one to forget that just time does move faster. I share the sentiment. So let's talk about your career. I'm a Goldman Sachs lifer. I believe you're a DK lifer. Is that correct? I am. Yeah. What year did you start?

22:11So I started at Davidson Kempner in the summer of 1998. I started as a summer intern. I graduated from Princeton University and was doing a joint law business degree at Columbia University. Davidson Kempner posted, and this is old school, on a bulletin board with probably a past dot matrix in those days, but a piece of paper posting for a full-time risk arbitrage analyst. I sent in a resume looking for a summer job. They said, hey, we think your background with the legal background is good for optimistic credit, come join us for a summer, which I did. And then I never left. And I never left because I was like, there's a billion dollars and 15 people here.

22:48That's probably really good opportunity for me. And I really liked the people I was working with as well. And I thought I could learn a lot. And those things just stayed for a very long period of time. I would have had no idea the level of growth that either we would have had as an institution or the industry would have had, but I quite enjoyed what I was doing from the early days of it. That was a wildly interesting time to start in the markets. Is there a lesson from those early days for you that you still carry with you today? In terms of investing, one of my lessons of investing, which certainly came from those early days and the discipline of Davidson Kempner is I always want to know in advance why we're going to lose money on something.