‘Who’s the Next Winner?’: Diameter Capital’s Scott Goodwin

0:05Welcome back to another edition of Goldman Sachs Exchanges Great Investors. I'm Michael Brandmeier, Global Head and Chief Investment Officer of the External Investing Group at Goldman Sachs Asset Management, and your host for today's episode. Today, I'm delighted to sit down with Scott Goodwin, the co-founder and managing partner of Diameter Capital Partners. Scott, alongside Jonathan Lewinson, established Diameter Capital in 2017, building an alternative asset management firm, which now manages approximately$25 billion in assets. Diameter Capital is best known for its distinctive approach to global credit markets, investing across the entire credit spectrum, from investment grade to distressed assets in both public and private markets.

0:54I'm excited to talk to Scott about his career, the longtime Goldman and Diameter partnership, his investment philosophy, and how he's navigating opportunities across the credit spectrum today.

1:11Scott, great to have you here. Thanks for having me, Mike. It's a real privilege. So I want to start today talking about today's credit landscape. Right now, we're talking about spreads are at about 3%, the 90th percentile. The private credit markets are wide open. you might even say booming. And defaults overall seem like they're relatively in check despite a couple of high profile defaults. So the high level stats are looking pretty good, but there are a lot of signs of stress out there. So you guys are professional skeptics. You make your money by looking at the downside and forecasting the downside, and you've done so successfully for a long period of time.

1:49Where are you seeing, I don't know if it's a canary in the coal mine, but where you're seeing the signs of stress. Sure. We've been spending a lot of time recently, and my partner, John Lewinson, who I founded the firm with, spends a little more time in this than I do. He's more on the research and macro background. But we'd spend a lot of time on the consumer in the US. Everyone knows the low-end consumer has been doing poorly. That's been true for a number of years. Now that's crept into the 20-somethings who aren't getting jobs out of college. What's interesting is if you ask the large banks, the JP Morgan's, the B of A's, how's the consumer doing?

2:18Their data would tell you that credit balances aren't up that much. Yes, people aren't paying their student loans because student loans, they didn't have to pay for a while. Now those got turned back on. So default rates have spiked there, but generally things look okay. What we see is, and this is another element of private credit, the online consumer lending, the Upstarts, the SoFi's, these are huge companies now. That's grown by 700 % in the past five years. So those are loans that aren't on bank balance sheets, ending up in insurance company balance sheets in many cases through ABS. and they're not showing up with the credit data in some cases.

2:52Right. So how levered is the consumer? We know what the spending is, but how levered is the consumer is a question we're really focused on. And then in the US, you're in this housing recession since the big inflation spike in 2022 that we're still in. We're not producing the number of homes we had been historically. Both new home sales and existing are terrible. And we're bouncing along at a really low level right now that is interesting because there's a lot of debt in the left-in market in that sector. And we think there's an opportunity there as the Trump administration and others do things to unlock the velocity of the housing market to put capital to work.

3:26So that's a space we see issues in. And we like to think about where there are cyclical issues, where there are secular issues. That strikes as a cyclical. Some of the population growth arguments might say there are very long-term secular issues. But I think you need a cyclical bounce first. Other things we see in the macro, everyone's been focused on Ozempic. And really, that's been a good thing for humans. but it's starting to be a bad thing for some levered companies. Especially you're going to have a pill next year for the GLP-1 pill, which will lead to an even higher penetration rate. We were comparing it to statins.

3:57And if you just look at the statin penetration curve, GLP-1s are way above that curve. And socially, it's probably something that you're more likely to take a GLP-1 than a statin for certain reasons. So if you see that penetration happening and you look at the demand for wine bottles, beer cans, things like this, some of these packaging companies that make the labels are really struggling. And that was a sector - Chips, junk food, all that kind of stuff. That was a sector that people would lend to without even thinking about it. It's a really safe sector. All of a sudden, there's a secular problem in that sector.

4:28A lot of credit investors who are index hugging or ratings focused tend to just, did I get my coupon? Did S &P and Moody's change their mind? Is management saying anything I'm concerned about? Okay, I'm fine. We really want to approach credit from more of a total return perspective, more of how an equity long short fund would. So what's happening in this industry from sector macro over the next three months, six months, 18 months, 24 months? And what is that going to mean for security prices in individual companies? What's going to change? So it sounds like on the macro, there's a lot going on.

5:01There's signs of stress. There's a lot to do. I want to come back to some of the thematics, but you started to talk a little bit about your process. So I want to go there next. One of the things I think that's interesting about you and John is relationships that you guys have across the street. You have relationships with David Solomon on down at Goldman Sachs. So one interesting, I think, example of how this really benefited your investors is Twitter. Tell us that story. Sure. So Twitter is a booming company these days, but for a few years, it was a hung deal. Elon Musk controversially took it private, cut 75 % of the costs.

5:37That's right. And EBITDA is now on its way back to$2 billion. But we had done a lot of work on it. There was a syndicate of banks that owned it for a few years. And they were clipping a nice coupon, 10%, 12%, 13%, depending on the piece of debt. And the numbers cratered. But we were pulling online data, scraping the data, trying to figure out what the ad dollars were that were going to Twitter. And we saw in Q4 of 2024 that they were really starting to inflect. Not only after the election, but also before. And then that led us to say, hey, maybe there's going to be an opportunity. for this to come to the public markets.

6:09Maybe the banks are finally going to sell this risk. So we started proactively engaging with a couple of the banks, one in specific that was the largest holder of the debt. And we were saying to the bank, here's what we think the earnings are. We have this data that we're pulling from public ad data, just like you would look at how many subscribers Meta has, like an equity long short fund would be looking at how many Facebook subscribers are there, how many Instagram subscribers are there and making bets on that. We were pulling that same data. And we also have sought out LPs, family offices in sectors like tech or healthcare, that can really help us be smarter on forward-looking trends.

6:42So it just so happens. We had a couple LPs, large family offices, that were also investors in X or Twitter. So we worked with them on the underwrite, and we went into the banks and provided them a bid. And they selected two people to do a transaction with at low 90s, of low 13, 14 % yield on the credit, which the credit we thought was sub 50 % loan to value. Now on a mark to market basis, post the merger with XAI, if you look at where XAI is rumored raising capital around 230 billion right now, if not higher, the Twitter debt is something like 5 % on TV or 10 % on TV. So it would be really off market at 13%.

7:19But we thought there was an interesting opportunity. It's not rated. It's not going to go in any indices, but it's not at the right price. And we don't look at ratings. We don't look at indices. We want to price things ourself and then see what the constraints are. And also, I just think it's interesting how you and John were able to create the transaction with those relationships. The one thing is the insight on the credit. The other thing is actually being able to make it happen. We believe in being very transparent with our bank partners, with our LPs. And part of being transparent with our bank partners is we share our research with them.

7:47We try to make them smarter, help them win deals. And in this situation, we were trying to make them smarter on X. And I think that helped to win the transaction. Yep. So staying on the topic of tech, we were talking a little bit ago about AI. And everyone loves to talk about AI in the context of the LLMs, about all the infrastructure plays. But you've got an interesting take on it and what is going to happen to the software market in the AI world. So let's talk about your sector views there. Sure. AI is, we like to talk a lot about microcycles. This is, as my partner, John, likes to say, this is a super duper microcycle.

8:23that will outlast many investing careers, hopefully not ours. So we actually started with AI in 2023. And obviously everyone was starting to use ChatGPT, trying to figure out what the impact was going to be. A lot of people were buying Nvidia stock. Our investors were not paying us to do that. So we did not have that option. There's plenty of ways they could get exposure to that. It's pretty good in retrospect. Should have bought it. But we were looking at, okay, who are the infrastructure players? Because there are a lot of, in the levered credit markets, there's a lot of telecom infrastructure, they're going to be big winners.

8:55And it was pretty clear to us when you looked at what was a huge CapEx cycle for training these AI models, when people actually started using the AI for inference to use it in Goldman or Diameter, using it to model companies or to build a software agent, then it had to leave the data center. You weren't just throwing chips and information at it and power. It had to leave the data center. How would it leave? It would leave on the commercial fiber, the pipes. So there was a company, a mid-sized telecom company, sitting within a larger distressed telecom company. And we bought the unsecured debt there mid to late 2023 at 30 cents on the dollar.

9:29We thought we were buying debt that was two or three times covered. So we made it a large position. We ended up doing a transaction with the company to give them more capital. Fast forward to 2024, they signed up 10 plus billion of contracts to provide large hyperscalers with access to their commercial fiber. And the debt's now at par. We take that a step further. We look at, okay, who's the next winner? If commercial fiber is going to be a winner, Spectrum is probably going to be a winner too because mobile data is going to have a huge increase when you go from IoT to robots to cars, cell phones, Starlink, whatever it is.

10:01So we made a big bet on a satellite company that was the largest owner of Spectrum in the US outside of the big telecom providers. We then did another transaction with them, provide them more capital, secure assets against Spectrum. Fast forward to this year, They have now sold Spectrum to larger entities and the debt back to par. But if I think about software, what's so interesting about the training phase, it's a lot of capex. There's issuance right now in the investment grade market. We participate in a transaction where one of the hyperscalers, they guaranteed a debt deal, off balance sheet, but back to back guaranteed at 150 basis points spread to the underlying debt.

10:39So 75 spread or 80 spread on the existing bonds, 225 on the new debt. Really interesting opportunity. but we have confidence in the cashflow of that company. We're also seeing a lot of opportunities in the chip finance space. Financing chips is something that we weren't really thinking about doing two or three years ago. It wasn't on the notepad. There have been some people who are at the forefront of that. We were not a leader there who made a lot of money. And now that opportunity set has become more broad-based. And you ask where we're seeing strange risks being taken. We did a transaction with another partner recently where we were at the senior part of the chips who amortizes over three years, earn a double digit yield.

11:14and then there's people taking the junior residual risk on these. And I just don't know. We call up really smart people in Silicon Valley. We call up really smart people at big tech companies and ask them what the residual value is on these chips three, four, five, six, seven years forward. None of them have a clue. I don't understand making a multi-billion dollar bet on that. That seems crazy to me. So we tried to stay at the upper end of the capital structure on the data center and chip financings. And then when you think about a big tech change in my career, when we've had huge technology changes, be they Amazon internet, it creates winners and losers.

11:46Yeah. Fracking winners and losers. Right. And the fracking is an interesting analogy to now with mentioned software. So you had fracking come along. Shale boom starts right after the GFC. When I get to Anchorage, we're learning all of these new issues. Yep. New issues in the Bakken and in the Mississippi Lime, in the Permian, all these basins. So we've learned all these basins. You look at hundreds of credits. This is the model. Know the names, learn the credits. So when something changes, you can differentiate and you can move quickly. 2014 comes along, OPEC decides to go to war with the share players.

12:19Oil crashes. And when you have a sector that at the time was almost a third of the high yield market and it starts to sell off, there's no differentiation. It is a high correlation sell off. People just went out and they can't sell the bad stuff at 50 cents. That doesn't get them out of that much of their exposure. So they're selling the Permian bonds at 75, 80 cents. Those are right back to par, as we all know. And the Mississippi Lime and some of the offshore stuff that was at 50 that we were looking at shorting went to zero. So there's real dispersion. So ChatGPT going to war with the software players?

12:51It's really interesting. You don't have an oil price going up and down like that. So the cycle now will be a little bit of a slower bleed. But if you look at Levfin private credit, about one third of that market is software SaaS LBOs. Yep. In between high teens percentage of the syndicated bank loan market, also SaaS. These have been great companies to lend to. Recurring revenue, not a lot of cyclical exposure. If I look back at COVID, obviously the investment grade opportunity, buying bonds in Goldman Sachs and big companies at very wide spreads in March of 2020, that was the first thing we wanted to do.

13:26But that opportunity was gone in about a month. And once that opportunity was over - By the way, I remember talking to the leader of one of the large tech buyout firms saying, These things, we levered them to nine or 10 times. You've got 95 % retention. These things cannot go into distress land. Well, here we go. We were buying tons of security-based software loans because the levered loan market, people were selling, they were getting outflows. We said, we're sitting at home. We're not turning off our antivirus. This seems like a great buy. We bought those at 70 or 80 cents on the dollar. They went back to par.

13:58You fast forward five years from then and the same security-based software companies we were buying and we exited at par, some of them are now distressed. Why? Not AI. Cloud providers went and took share from them because they were too levered and they couldn't move fast enough. Most of those LBOs are pre-GPT. We asked - Just think about that for one second. ChatGPT was not even being discussed in the investment world, not even talking to the general public. In general, maybe it's in some of the venture capital firms. Sure. The smartest venture capitalists will probably focus on it five, six, seven years ago.

14:31Exactly. The buyout firms in general, we're not even talking about that. I think it's an interesting point. No. And we've asked some of them and they went from zero time with the IC to a quarter or a half. Not just negative, but what are the positives? What are the negatives? It's a risk factor. I want to understand how I can win or lose from it. So we focused on originating in our left-in private credit business, more of the post-GPT SaaS deals. People are aware of the risk. They understand what the mode is. Maybe it's even a benefit. it. What concerns me is the vintage of deals, the vintage of left-in private credit, where left-in private credit is going very fast in the late teens and early 20s.

15:08A lot of money floated into the asset class. Many big public alts managers growing, issuing, doing every deal they could to raise the next dollar because the fees are very high. You end up with one third of your portfolio in one sector. In credit, that's horrendous portfolio construction. In equity, I get it. You have convex upside. You can make a money multiple. Completely understand it in either syndicated bank debt or left in private credit where you're issuing the debt at 98 or 99 cents on the dollar. And it's callable then at par. So you can make one or two points of appreciation plus your coupon.

15:39I think it's almost criminal portfolio management or portfolio construction. You really need to think about what you're doing because defaults tend to cluster. Now, it reminds me of you mentioning in 13 and 14 was happening in the oil and gas sector. I think oil and gas got up to what? Probably close to 20 percent. Higher. Higher as a percentage of Of the index, now it's probably less than 10%. Great example. Yeah. So I'm not saying all SaaS companies are bad. In fact, I think most SaaS companies will be fine. Yeah. But the SaaS companies that got LBO'd pre-COVID, late 20-teens, and through COVID weren't necessarily the S &P 500 largest SaaS companies in the world.

16:15They were, in many cases, 1 to 10 billion EV companies with not, they were slower growth, not good growth, but slower growth, and rip out some costs, change the go-to-market model, do some M &A, re-IPO, sell to another private equity guy. It's been a great repeatable strategy for many private equity firms. But the issue is, when that starts to go bad in SaaS, when you start to turn subscribers and your retention goes from 98 to 95 to 90, and we made a mistake in a SaaS investment diameter in a software investment in 2018 when they started to lose subscribers, we doubled down on the distress. We learned our lesson.

16:48When these things start to go bad, it's not like you have oil in the ground. That cash flow scheme goes away. And the docs on a lot of these loans aren't such that you can take the asset for a very long time. They're weaker docs. So I would be concerned about what the eventual recoveries are going to be, even if the default rate isn't extreme. We do expect increasing defaults there, but also very low recoveries given default. And so, Scott, are you in the mode of finding lots of active opportunities right now? Or is this the diameter period of get to know everything and wait for the opportunity to come to you?

17:19In the software space? Yes. In energy in 2014, we were shorting. Right. Because they were high yield bonds. So you could go and say, which are the companies that are the highest on the cost curve at the worst economics, short those. Here, most of them are not in shortable asset classes and they're with sponsors that we wouldn't want to short their credits anyways. So you're in syndicated bank debt and private credit. You can't short those asset classes. There's no borrow in them. So it's learning a lot of credits, knowing the names, which is our model, having that CLO business, the private credit business sitting next to each other, a lot of research cross-functional across the two, understanding as many credits as we can, so that if there is a time when the tide goes out on SaaS, we'll have an opportunity in our hedge fund, in our drawdown fund, in our CLOs, in our private credit business to buy the good businesses at the wrong price.

18:08Similar to what happened in energy. Yep. I'd like to pivot again and talk a little bit about the origin story of Diameter. We go back together as firms. And I'm proud to say that we were at a minimum early in getting behind you and John. But tell us about the story. I think it's a good one. Sure. So John and I, as we talked about earlier, met at Anchorage in 2010 when I joined from Citi. He had been there for a few years and he had been named head of research. So he sat on top of the research. I sat on top of trading and we both helped manage the portfolio along with the guys that founded that firm.

18:44We started as early as 2011 going to breakfast. We have sons that are the same age. And we both lived in Tribeca. Going to Bubby's, which is a famous restaurant in Tribeca, in pancake inflation like you've never seen. People wait in line for an hour every weekend to have$35 pancakes. Amazing. Welcome to New York City. We would go and have breakfast with our sons and talk about credit. And John, at one of his breakfasts, after about a year of being together in Anchorage, said to me, I think we should start a business together. And I said, well, that sounds great, but I don't know if I'm ready. You know, I've been here a year.

19:14I need to learn more. But we kept talking about it. And we had a deck in 2012. And then in 2013, he decided he wanted a different challenge. And he went to a firm that was a little more focused on distressed. Anchorage was very focused on underwriting the business side of the asset side of the balance sheet, the business. He went to a firm that was more focused on the liability side, learning kind of the dark arts of the docs, which was good for us now to have both. So he left. I stayed. I had more to learn there. But in 2016, when it came time for me to leave Anchorage, I reached out and said, hey, We've been doing these breakfasts every weekend talking about this.

19:45Still, we were doing them after he left. They became even more important. And we got together and we said, okay, let's do it. So we started in early 2017. But Steve Bossy, who used to be in your group and has since retired and is on one of our boards now, reached out to me the day I left Anchorage. And I met with him and Kevin Kelly, who ran Prime Brokers at the time for Goldman, and Jason Browthard ran credit the next day. And they said, listen, we want to be involved with whatever you're going to do. Yep. And not everyone in Anchorage wanted them to be having that meeting. So I thank them for having that meeting.

20:15And a big credit to David and John, not only was GCM a day one investor, but David was the first visitor when we moved on our small office in Bryant Park. He was our first visitor from anywhere. Yeah. David Solomon, our CEO. Yeah. So he was the first visitor from anywhere. And John Waldron, who's the president of Goldman, has been an incredible advisor to us as we built our business. So we owe a lot to Goldman as a firm, as a true partnership. I say that in the most sincere sense of the word. Yep. Well, we deeply value the relationship and the way that you guys put this firm together. It reminds me a little bit of Led Zeppelin.

20:46Jimmy Page and Robert Plant really had a vision of what they wanted to do, and they got it right on the first album. You guys are the same way. Talk - Only as good as our last trade, though. We've got to keep going every day. I mean - Exactly right. I want to talk about sports for a minute. You're a sports nut. You've been into sports, but The Boss is Back is such a great story about how you got interested in investing. and you were right there at the inception of fantasy sports. Yes, sir. Tell us about how that started. So huge Yankees fan growing up, Hitman, Don Mattingly. I would get USA Today baseball weekly every week, go through the stats, learn about the team.

21:22So the Yankees in the 80s, they were not very good. The Mets were the strong team in the New York area. So all my friends were Mets fans. I was a Yankees fan. For our younger listeners, the newspapers used to have all the stats in the back in the sports page. That was where you would get it. USA Today had this thing called Baseball Weekly, and I saw there was something called Bill James Fantasy Baseball. Anyone who's listening who's a Red Sox fan will know very well who Bill James is. Bill James was hired by Theo Epstein and that group to help bring sports data into the Red Sox. But before that, he was the godfather of rotisserie or fantasy baseball.

21:56He worked with a company called Stats Incorporated, which is now an LBO that we lend to, ironically, to build this fantasy baseball thing. I signed up. They sent me some spreadsheets, fill them out, your draft picks, who do you want where? I sent them back. I get the week before the season starts. This is probably 1988, 1988, 1989. So I'm eight or nine years old. I get them back. Here's your team. Here's your players. And oh, you're in the league with 15 other people around the country. Here are their emails. These are like AOLs and Yahoos and Hotmails. And here's an MS-DOS prompt. You can go on and see the stats, but very clunky dial-up modem type stuff.