#134 - Steve Ketchum: No Called Strikes in Private Credit

0:00Steve Ketchum:Welcome to the Insightful Investor Podcast, a weekly series that seeks to share industry, investment, and market insights. Learn more about our show at insightfulinvestor.org.

0:15Steve Ketchum:Steve Ketchum joins us on the podcast today. Steve is the founder, CEO, and CIO of SoundPoint Capital Management, a credit-focused asset manager. Today, we're going to discuss how he thinks about credit cycles, private markets, and where disciplined investors can potentially find opportunity in periods of stress. Welcome, Steve. Alex, thanks very much for having me. Let's go back a little bit. So when you reflect on your path into credit, what early experiences do you feel most shaped how you think about risk and opportunity today? That's not going back just a little bit. That's going back a lot.

0:48It's a great question. So, you know, I started my credit career 35 years ago. I was a just graduated from business school. I was an associate, a lowly associate at a firm called Donaldson, Levkin, and Genrette, which was later sold to Credit Suisse. So when I talk about my background for new joiners, you know, in their early twenties at sound point, I say DLJ, their eyes glaze over, but we were for the 10 years I was there, we were the dominant, um, underwriter of higher bonds and leveraged loans and the largest restructuring advisor. So it was a phenomenal experience for somebody who ultimately chose credit investing as his career.

1:29Tony James, who went on to Blackstone and to be the number two person at Blackstone under Steve Schwarzman, was the person who ran banking, was a brilliant guy, incredibly analytical. As a result, we as a firm were highly, highly analytical. when we ran a model, the only thing that Tony and other senior people were focused on was the downside scenario. Did we, and downside doesn't mean only 2 % growth per year in revenue. It's, okay, what happens in a cycle? What happens in a recession? What happens if there's an idiosyncratic train wreck? Did we capture the worst case scenario? And I think the other thing which sounds quaint today is when we looked at a leveraged buyout, a company we were buying or a company that we were financing, we wanted to run a model that allowed the company to organically pay down the debt that it had taken on.

2:34And in today's world, there is no leveraged buyout, no loan, no bond that organically pays down. You're really bridging to a refinancing. But when I started 35 years ago, that wasn't how we thought about credit. We wanted to lend money to companies that could organically pay us back through free cash flow.

2:56Steve Ketchum:So you founded SoundPoint in 2008 amid the financial crisis. How did that fundamentally shape your investing mindset? It introduced me to the concept of fear and investing with fear, which in credit is a good thing. It's easy to look back when I give investors that were meeting for the first time in the background of the firm, they said, wow, what a great time to start a credit business. I think it's easy to look back and say, well, gosh, things were trading at 50 % discounts. So what a phenomenal entry point. Well, there was massive systemic risk. Nobody knew what the government or the Fed might do to help stave off another depression.

3:40And so it was a scary time. And so we tried to be very thoughtful about upside, downside, asymmetric risk. We really tried to harness what we thought was the absolute worst case scenario if we're buying a loan or bond at 60 cents. And we thought that absolute worst case scenario, the downside was five points. And we thought the upside might be 20 or 25 or 30 points. Well, that was five or six to one asymmetric upside, downside, and that was good. And in retrospect, most of the things that we invested in during that time, 2008, 2009, even early 2010, proved to be successful. But at the end of the day, what it really did teach us is to make sure we understood, before we thought about the upside, what we really learned in that period was to focus on the downside.

4:37So when you think about marrying that, that was 18 years after I started as a credit analyst at DLJ. It was really tying those same two concepts. What is the absolute worst case scenario in terms of downside risk that we were taking?

4:52Steve Ketchum:You know, with perfect hindsight, it looks obvious. But living, you know, I lived through that like you did. We were on the precipice of a Great Depression. And you didn't really know how that was going to turn out. So measuring downside when you're looking over the cliff is different than in a normal environment. So that is, I think, it can really shape how you think about investing. Completely agree. So how has your definition of a great investor evolved over the 35 years or so you've been in credit markets? Yeah, it's a great question. And look, I think the definition of a great credit investor is quite a bit different than the definition of what might make a great venture capital investor.

5:36And so maybe the first mantra, the first and maybe the most important characteristic is thinking about return of capital before return on capital. And I think what's happened, it's happened recently, and it happens really in every credit cycle, getting excited, trying to stretch, going for maybe a bigger spread and taking more risk than one should might seem fine until there's a problem. And so if we're hyper-focused on making sure that the principle that we deliver to a company as a loan or in the form of a bond, if we feel highly confident that we will get our principal back, then the returns tend to take care of themselves.

6:26Return in a fund tends to be impaired not by finding things that don't have enough spread. They tend to be impaired by the mistakes that one makes. So that's important and always been important. I think the other thing that I really did learn along the way is it's important to do the underwriting and the credit work and look at the worst case scenario. And I think what happens again, and not just in credit, but in other asset classes is, and this is less about private credit than it is about distressed or opportunistic, you know, performing credit, liquid credit. You make your investment, your thesis is good, that particular instrument trades up, it creates a return, and you get excited about it.

7:18You've been right, you fall in love with your position. And at the end of the day, I see a lot of investors who do great work on the front end, and their investment realizes the potential that they expected, and they forget one important thing, which is to sell and to lock in that upside. So if I've done my work on that 60 cent bond or loan, where I think the downside is five points, and I think the upside is 25 points. Well, when that loan or bond trades to 80 or 85, that's time to sell that position, take profits. No one goes broke taking a profit. And so that is a hugely important lesson. I think the other, and we could spend the next hour talking about all the lessons I've learned, I think the third thing that we try to emphasize in our IC and when we think about things internally in terms of a process, there are no, I'll give you a sports metaphor, there are no called strikes in credit investing.

8:25And I'll come back in a moment and talk about why that's different than other types of investment. But if we're putting out capital to a company and everything seems good, but we just have unease about management or the industry or something idiosyncratic to do with the company, it's easy to take a pass. Right. Because we don't have, as opposed to a venture capitalist who might be looking for a 10x type return or more, we don't have as much convexity. And so we might pass on something and it may turn out fine. But at the end of the day, that that's OK. Would rather if we have concerns or misgivings would rather pass.

9:08if I'm a venture capital investor and I pass on a B round for SpaceX when the valuation is 20 billion. And then I wake up in X number of years and the valuation is 1.8 trillion. Well, that's, that might be bad for my career, but, but in credit, I can take a call strike and go on to the next one.

9:31Steve Ketchum:And it's largely because it's less about the upside and more about minimizing the downside. So you don't, so the winners don't stand out as much as the losers do. You're a hundred percent right. As I said, and we talk about this a lot as we talk about our process internally at some point, it's the losers that will define, you know, how this vintage of, of fund works out, not the winners. And how do you think about waiting for the fat pitch versus staying fully invested? Well, I think, you know, the good news is our investors have taken care of that problem for us. What do I mean by that? Well, you know, in the aftermath of the great financial crisis, there was probably more credit capital, overwhelmingly more credit capital, especially in distressed and opportunistic credit in the form of hedge funds, right?

10:30So that creates a conundrum because if you've been fortunate enough to have raised billions and billions of dollars, but you only find, but you're being thoughtful and you're waiting for those fat pitches, that means that you might have to run with some cash in your portfolio. Now, that paradigm has shifted because more and more investors in the mid-teens pushed managers like us towards drawdown funds, which means that you You wait until that fat pitch to invest capital. So there's a bigger mix. There's still plenty of hedge fund style funds. There are interval funds, which are obviously not drawdown funds.

11:15So there certainly are many funds that continue to be evergreen type funds. But there is a bigger percentage of the overall capital that we and our competitors manage that are in the form of drawdown funds. And so that ameliorates the issue of, gosh, what do we do? We're charging people fees. We don't want to have an abundance of cash sitting in a fund. So that's become less of an issue today than it was perhaps in 2012 or 2013.

11:44Steve Ketchum:One concept we talked about last time you and I talked through some of these things is you like the idea of having more ideas than capital. Would you talk about that concept? There are two sides of that equation. One is making sure that we have a pipeline. And whether it's with our private equity business, where we're sourcing and structuring and underwriting and then servicing loans, where we're the admin agent and we're controlling really all aspects of that. But then we also have a performing credit business and an opportunistic credit business where we're going out and buying things off of Trading Desk or Bloomberg.

12:25So part of it is making sure that we have an appropriate team of people facing off against each opportunity, putting ideas. You know, I think about it, if you think about it as a funnel concept, you need to put ideas in the top of the funnel. And you certainly, it probably wouldn't be a good result if you did 100 % of, or you executed on 100 % of the ideas that went into the top of the funnel. So you want to come out with a small percentage. I think that suggests better performance in the long run. But then there's the other side of the equation, which is harder for a lot of folks that sit in our shoes.

13:07So that's the part where you have to show restraint and you have to hard cap a particular fund. We raised a fund recently in our capital solutions business. We had a lot of success. We imposed a hard cap on ourselves of$1.5 billion. It was our strategic capital fund three. And we could have raised multiples of that. But I and we and the team knew that it would be more prudent. The third fund was larger than the first and the second fund. And so we were delighted that investors showed their loyalty and their appreciation for the returns that we had driven in the first two funds, but we didn't feel that we could properly deploy four or five or$6 billion.

13:58And so we imposed that cap. And that's the definition of being long-term greedy as opposed to short-term greedy. And I've been around long enough to see that movie where a firm takes advantage of great returns and the enthusiasm of their investor base raises too much money in their third or fourth fund. And guess what happens? The performance of that fund is subpar. And that means the next fund is either non-existent or much smaller. And again, we've seen that movie and would rather be patient.

14:38Steve Ketchum:And going back to what you described as the funnel, because when you have a larger fund, it effectively constrains what can come out of that funnel. So So you sacrifice some quality for asset growth. Exactly right. So when you look back at periods like the GFC, which you talked about earlier, one thing that was interesting is you had unexpected upside. So how do you think about, you talked about asymmetry. So how do you think about that experience when you're assessing downside versus upside in credit? It sounds trite, but I do think, and it goes back to a few of the themes that we've been talking about.

15:16If we do our analysis correctly, like I learned 35 years ago as an associate at DLJ, and we think about the asymmetry, if we're wrong about the upside, it's not a disaster. If we're wrong about the downside, it could really and truly impair performance. So we couldn't control what some of the macro factors, the exogenous factors that happened that helped create upside if you were fortunate enough to invest in credit in 2008 and 2009 and even early 2010. But because we did a good job of maintaining or limiting our downside, we could be patient and wait for that, wait for the upside to manifest itself.

16:03and we'll be in other cycles where we make an investment in that 60 cent bond where we think there's five points of downside and that 20 or 25 points of upside won't come. But maybe we'll be clipping coupons. Maybe there'll be five or 10 points of upside. So it won't be a disaster, but it might not be a 30 or 40 or 50 percent type return environment. But that's OK. You can live to fight another day as long as you're not looking at a 30 % loss or drawdown in your fund because you haven't been as thoughtful on the downside as we want to be. Yeah, basically, just make sure you don't strike out.

16:46Steve Ketchum:You'll get occasional fat pitches and some you'll miss, but as long as you don't strike out, you can keep playing. We're happy to follow off pitches. We're happy to bunt. We're happy to hit a single and then sacrifice, you know, the, you know, the runner to second base, we're just not swinging for the fences in what we do. Again, in venture capital, it's a completely different world. In credit, it's all about minimizing the downside. We live in a world where the macro seems to have an outsized impact. How do you, and you talked about macro, how do you incorporate macro without trying to predict it?

17:22You know, so when we think about macro, we're not a macro fund per se, right? So we're not positioning our portfolio based on a hunch or an educated bet that the price of oil will go to 150, right? Because again, as opposed to equity investors, we don't own typically, unless we're buying a deeply distressed loan at 10 cents on the dollar, there isn't as much convexity. The equity investor owns the upside in a commodity like oil, we're capped out at par or something close to par, but we own, you know, theoretically 100 points of downside, right? So when we think about macro, it typically is more about avoiding risk.

18:13You know, we talked a lot internally about going back two years about AI and the impact that AI could have on the software sector, which happens to be a meaningful sector, both in broadly syndicated loans and in private credit. And so we are fortunately massively underweight software in our private credit business. We have 3.7 % exposure in our core middle market lending business, 0 % exposure in our capital solutions business, in our broadly syndicated business performing credit business, we've got about 7 % exposure, which compares to 14 % for the overall market. And so that was less about, okay, we like AI, we think it's got potential for upside.

19:02How do we harness that? We looked at AI just like we did in 2015 in the energy sector, when we had concerns about about where the price of oil was going to underweight as opposed to overweight. So that to us is the big difference between how we would think about macro as credit investors versus equity investors or venture investors.

19:27Steve Ketchum:So thinking of it in terms of what could be the negative factors and when there's a big potential negative, you just steer clear effectively. Right. And again, it goes back to this common theme of looking at downside and another another great. We had we had excellent performance in our in our hedge funds, our credit hedge funds in 2015 and 16, because we had almost no exposure to energy in a in a time where credit investors were overweight. and the price of a barrel of oil went below 30. And that created a depression in that particular sector. And how do you think about the current interest rate environments and the role of Fed or fiscal backstops when you're thinking about the downside?

20:18We've got the great good fortune of the 90 plus percent of the instruments in which we invest in, And again, whether it's our performing credit business where we're buying loans and bonds off of trading desks and off of Bloomberg's, or whether we're creating our own manufacturing, our own credit in our private credit business, the vast majority of what we do is floating rate in nature. So the good news is we don't have to diagnose or predict where the short-term rates as measured by SOFR go if they there's there's some modest impact, but it's not significant. So, of course, we we're aware of what's going on.

21:05We we look at the environment today and we see some inflation. And our view is likely there's not a path to lowering short term rates dramatically. But again, we're positioned in our portfolio so that what generates returns or what is instructive in terms of the returns that we get is much more around the credit work that we do than properly predicting where short-term rates will be in a year or two years. I wouldn't want to be Kevin Warsh. It's a hard job.

21:40Steve Ketchum:And I assume you don't expect or assume as part of your analysis that there is a Fed put or a fiscal backstop if things turn south. 20 or 25 years ago or 35 years ago when I started in credit, nobody knew what a Fed put was. And I think it is dangerous to think about that going forward as a driver of returns. And again, I'll sound like a broken record, but if we do a great job minimizing our downside, protecting our downside, and there is another cycle and there is some sort of impact on the financial system and at some point in the future, there will be, we'll go through another cycle. I don't know what will drive it.

22:28I don't know when that will happen. But if we do a great job of protecting our downside and the government steps in in some way to intervene and that helps drive upside, that's a good thing. But that is not, we don't and would never position our portfolios to take advantage of a Fed put.

22:51Steve Ketchum:Are there any early signals you watch for that that credit cycle may be turning before it's obvious in the data? We started out as focused, hyper focused on just corporate credit, which is what my background is. We added several years ago, a commercial real estate credit business, which is it's which is in a very interesting cycle right now. But we also have a consumer focused business where we manage capital where we go in and we buy packages of loans from fintech companies and originators that compete with the banks. The beauty of being in that business and the fact that we think we do a very good job of creating synergies among, I hate to use that term, but it's the right term, creating synergies among our various investing groups, is that in the corporate credit business, we usually get data from our issuers every three months.

23:53That typically is the cadence. In some cases, we get some information monthly. In our commercial real estate credit business, that tends to be more of a lagging indicator. So we get information that might imply the start of a cycle from our corporate issuers before our commercial real estate credit issuers. So our commercial real estate credit team appreciates the dialogue with our corporate credit team in terms of looking for green shoots of negativity. But the consumer business, we're getting information on a daily basis about payment defaults and payment extensions. And so that is incredibly helpful to the rest of our business.

24:41And there's nothing that we see now that concerns us in terms of the strength of the consumer or spending or defaults. But that really is a secret weapon as we look at our broad business, because the indicators that we get come much more quickly on our consumer and our consumer business than our corporate or commercial real estate credit business.

25:03Steve Ketchum:Are there any assumptions, think of it as like maybe general assumptions about private credit today that you think may be too widely accepted or potentially flawed? It's an interesting question. And if we were, if this was a summer 2025 podcast, the first question you would have asked me is, are we in the, you know, are we in the golden age of private credit? Because I think every morning when I woke up, there was some sort of article or piece on the golden age of private credit because there had been tremendous growth. And that's that's always, it's always dangerous to, you know, when credit gets too exciting, credit is meant to be, to be boring.

25:49I think, you know, when I'm on a panel, a hundred percent of the time, I've gotten a question from the audience around systemic risks. So we're not, or we've moved from, you know, asking about, are we in the golden age of private credit to, okay, are there systemic risks? Will private credit create the next downturn? And it's important to dissect that a bit because, you know, a significant portion of credit capital loans have moved off bank balance sheets onto the balance sheets of firms like ours, the funds that we manage or the separately managed accounts that we manage for insurance companies or family offices, et cetera.

26:38If you think about the great financial crisis, coming into the great financial crisis, banks were levered at 25 or 30 or 35 to one. And they had some toxic things on their balance sheets. And that was a bad combination that created massive systemic risk. Most of the capital that we have, let's talk about the private credit the side. Most of the capital we have are in funds that either have no leverage or a turn or a turn and a half of leverage. So a fraction of the leverage that was in the system back in the great financial crisis. So that's number one. So it doesn't guarantee that there won't be a mistake.

27:20It doesn't guarantee that there won't be a spike in defaults. But what it does suggest is that the impact of any cycle will be de minimis relative to where we were in 2008 when bank balance sheets were levered the way they were. That's number one. Number two, the professionals, the investment professionals that make the decisions for SoundPoint and for our competitors are better aligned with our model than they were in the bank model. And I've worked at banks, and so I've got some visibility. So bankers tend to get paid on fees, and portfolio managers and analysts and traders at a firm like Soundpoint Capital get paid on the returns that we generate for our investors.