The Golden Age of Absolute Returns?  With Davidson Kempner’s Managing Partner and CIO, Tony Yoseloff 

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25:43So one of the hallmarks of late cycle behavior is a deterioration in lending standards and documentation, etc. Have you been observing that? Yeah, I mean, completely. I mean, so my truisms of investing are that capital chases returns and markets become efficient over time. And if I go back to the growth rate of direct corporate lending over a long period of time, if you go back 10 years ago, what were those firms offering? They were offering speed and one-stop shopping in terms of competing. And in exchange for that, they might ask for a little bit more coupon and better terms and conditions. And I think since sponsors probably assumed their deals were never going to default anyway, they were willing to give that up.

26:24In the last five or six years, private equity sponsors have not had to give that up. And the reason, so i.e., the covenants that exist in larger cap direct corporate loans are substantially similar to what you would have in public markets. So there are some defenses that you have in private markets that you don't have in public markets, i.e., the lenders can all get together and avoid some of the creditor-on-creditor violence that you've seen, quote-unquote, in public markets. But fundamentally, that can break, too. You know, if you've got a syndicate with 28 private lenders in it, is it really that private anymore, right?

26:56Is there much more of a risk that a few folks are going to break ranks? The answer to that is yes. And I think you'll see more of that over time in that asset class. But the fundamental reason why competence fell away was competition. And as a lender, you're not giving something up on price. You're giving up a term and condition that in a smaller subset of your deals is going to matter. But in a larger subset of deals, when you get paid back, it's not going to matter. So it was an easy give, I think, relative to giving on price. I think ultimately, direct corporate lenders had to give on price, too, to get transactions.

27:27But that's all just the sheer amount of capital pouring into an asset class and capital chasing returns and the natural efficiencies that you would expect happening in a functioning market happen. It's much more of a U.S. story, by the way, than a European story. I mean, the U.S. markets are much more dominated in terms of leverage finance by direct corporate lending than it is in Europe. But in the U.S., it's very prevalent. And you would expect these things to happen over time. The average pricing of a venture capital deal today, first round, far higher than it was 10 years ago. Why is that?

27:59There's just a lot more money chasing the asset classes. People have done well. And so, you know, none of these markets are immune to the basic laws of supply and demand. So we're going to come to non-US in a minute. But before we leave this particular segment, one could say it's a euphemism, but the term applied to the current situation in private equity and private debt are blockages. How does this get worked through? So I hope I'm not providing bad news to folks who are listening to this podcast, but I think it could take a lot longer than people think to work this through because you have to worry about what incentives are, right?

28:41First of all, private equity funds generally have 8 % preferred returns on them, such that the firms are not going to earn carry unless they hit that. Then the second thing is that the model of private equity means that you always need to raise another fund to be in business. The benefit of absolute return strategies is if you do your job, you're growing the capital naturally. So even if your investors need to withdraw a little bit to pay their own bills or whatever it is, like you actually grow AUM just by doing your job. You know, when you do your job in private equity, you return AUM and you have to go raise another fund.

29:18I don't know if the right stat is that there are as many private equity funds as there are McDonald's franchises or not. I've had a harder time validating that. But there are 100 % as many private equity funds as there are Burger King or Wendy's franchises in the United States, which is more like$6 ,000 versus$18 ,000. And if you look at the proliferation of that asset class in the 2010s, and you look at both where returns sit today and you look at where investors are allocating on a going-forward basis, you're going to have some real contraction in both number of firms and size of firms. And I think it's going to be very barbelled.

29:53I mean, I sort of joke it's like the club world. The clubs that people want to be in, everyone wants to be in. And the clubs that people don't want to be in, no one wants to be in. Right? And you have this bifurcation. And the clubs that are popular remain very popular. And the clubs that aren't popular go away, right, or consolidate. And I think you're going to see that. I think that just takes a several-year period. And then you couple that with the fact that you've got a large number of loans that don't make sense today based upon debt-to-LTV or interest coverage tests or any number of different things you're going to look at.

30:25and you've got very porous documents. So 90 % of the documents in public markets are Covenant light. And this actually is something in public markets that started to come more to Europe. And in private markets, I think for recent deals, it's probably not gonna be that far off from that number. And sponsors have time and sponsors have flexibility and sponsors incentives are not always gonna be straightforward or known. And that can just lead to things taking a really long time. Look, they're gonna be one-offs, right? There are businesses that sit in sponsor world that are very large beneficiaries of some of the AI CapEx that we spoke about earlier.

31:02It's not like every business is going to be bad. In the software world, even let's say the most challenged part of the asset class, there are going to be businesses that are AI winners that are able to use AI to improve their offerings, that have a moat around them that investors maybe aren't respecting today. And maybe you'll get some of that multiple back that you've lost. I don't think you're going to get it back across the industry, but you might get it back in a handful of specific investments. And all these things take time. And there's time that's in the process, and there's time that's in inertia.

31:33And then there's time just proving out your model, right? So let's just say you've got a business where there is some stealthy growth to it. When are investors going to give you credit for that? Two years later? Four years later? And so, I mean, that was the timeframe in the early 2000s, I think it was, for people really to give you credit for sustainability of cash flows. And I just think it's going to take several years for this to work itself out. I think the excesses of the 2000, let's call it 18 to 21 era, were just so large that there's not a simple solve for this. So you've been on record being quite excited about the opportunities that are being presented.

32:11How do you expect to take advantage of them? I think there's a lot of different ways that you can do this. And I think it does toggle across the public markets and private markets. So I don't think it's either or. I think it's both. In private markets, I think there's going to be many sellers of capital structures or pieces of capital structures where, you know, if you view direct corporate lenders essentially as the new banks, right, they will have workout groups. Some of them have workout groups already. You're not going to sell everything. You are going to choose to work some stuff out, right?

32:43But you may prioritize larger loans over smaller loans. You may prioritize loans where you can have more of a direct impact and others can have a direct impact. And, of course, you'll think about the price that you're being offered for them. You've got sponsors who are fighting for their lives and deals where there is equity value. There just is too much debt on the transaction, and they're going to look for capital partners in that area. You'll have old-fashioned restructurings where keys get turned over. And then I think there's a lot of natural growth capital, actually, that maybe isn't attracting private capital because too much of the private capital is gummed up in this other stuff.

33:19And so it's just less readily available. So things that would have been readily financed four or five years ago were having harder times finding capital partners and or the price of being that capital partner is much higher rate than where things were. So I think all of the above in private markets is like in play in terms of where you'd invest. And then I think you're going to have many natural ups and downs in public markets to boot over that period of time. I mean, we haven't really talked that much about outside the U.S. too. The markets outside the U.S. look very different than the markets look in the U.S.

33:54for the most part. You know, maybe outside of Korea or Taiwan or something like that. They've not had that AI bounce the way that you've had in the U.S. in public markets. And so I think there's just a lot of ways to play that theme. And this does actually all go back to rates. The cost of capital is not high, but it's higher than it was previously. And that just creates tremendous opportunity in a world where a tremendous amount of the capital structures were still set in a period of time with lower rates. I'm smiling because, you know, Japan this morning, Bank of Japan put up rates to 1%. It's been 30 years since they were short rates were at 1%.

34:31But I'm really interested in the subject of returns and return expectations of, you know, institutions such as Yale that has pulled back on its private asset allocations. It's not alone in that. Do you think that generally, in the excitement of the lower rate environment and the capital allocations that followed, that return expectations of those long-term investing entities, endowments particularly, has been unrealistically high? Well, look, I think that universities or top allocators are not immune to the capital chases, returns, and markets become efficient over time phenomenon of markets. Actually, our president at Princeton University, Chris Iscuper, wrote about this in his annual letter earlier this year.

35:21My joke was, you know, it's fairly rare that a university president's annual letter is going to be more covered by the Wall Street Journal than it is by the Chronicle of Higher Education. But that was the case. And one of the things he spoke about was the fact that returns have come down over very long periods of time. And I go back to simplistic things like some of the strategies that these Ivy League schools, you know, really created. I mean, David Swenson goes back to the 1980s in terms of these strategies. Creative and institutionalized are now monsters in terms of the size of the asset classes.

35:55And it's not that you can't generate great returns in these strategies. You're just not guaranteed to generate great returns in these strategies. I don't think that because a strategy is private that it's immune to the supply-demand dynamics of any other strategy. If too much money is chasing a strategy relative to its opportunity set, the likelihood is that returns are going to suffer over a period of time. And so I do think allocators need to be realistic about what things can achieve on a going-forward basis versus where they are today. It's not to say that people can't occasionally achieve really outsized returns.

36:29Obviously, you've seen them in the growth space in a handful of these very large AI-linked companies. You have seen them in private markets, too, in some of the CapEx providers, right? You know, I actually cut my teeth early at DK working on power plants. And, you know, for 25 years, no one wanted to talk about power plants. For 20 years, no one wanted to talk about power plants from the mid-2000s to today. Now, all of a sudden, everyone wants to talk about power plants, right? So a skill set that wasn't that valuable became very valuable again all of a sudden. So there is some cyclicality to these things.

36:58But fundamentally, you're not immune to supply-demand things. And so I think investors just need to understand if you're in competitive strategies, you can't look in the rearview mirror to what returns were 10 or 15 years ago. I do think this dynamic will turn right side up in private equity again. It just might take another five or 10 years. It just may not be overnight. Let's just turn from the U.S. scene to the global investing landscape. And I'm thinking here about, it was Barton Biggs formerly, you know, Morgan Stanley, you used to talk about the global efficient frontier. and international investing was one way to capture and optimize those returns.

37:34Now, of course, that's been dumbed down by larger returns in the U.S., but how do you think about that international investing equation? Yeah, so I actually think Barton is still correct where there's real alpha to earn outside the United States. And some of it is market structure, some of it is regulatory structure, some of it is fewer people playing. The part that I think has been harder more recently is what you alluded to, which is, you know, beta has done so well in the United States that even if you generated a lot of alpha outside the United States, your overall return may still look better in the United States.

38:10From my perspective, that will equalize over time. You know, if you look at valuations in Europe, for example, compared to the U.S., and you exclude the tech-related investments that you have in the U.S. that maybe you can't access through European markets in the same way, Europe is still really cheap on a 30 - to 35-year basis compared to the U.S. And so we're very happy to take our chances on earning alpha outside the United States and having that as a tool in the toolkit. And it has to compete against the U.S. in terms of rates of return. And so, you know, for our investing strategies, they do, you know, generally wind up being majority in the United States.

38:51But I would say relative to the size of the markets that we're investing in, the international markets more than punch above their weight for us with where they're investing because of this alpha component. And, you know, one of the things I think is really phenomenal as an allocator is I get to sit on top of all this. And, you know, if we think really interesting things are going on, you know, we've been very public that we think there have been great lending opportunities in India. For example, you can go a little bit deeper in that and put more capital to work in that. If there are other markets that aren't giving you that opportunity, you can do less.

39:21Now, there's usually not nothing to do in a market. Like there's usually always something to do in a market. But in terms of allocations, you can swing more. you can swing last, just like if you're running a portfolio with equity and credit, you may sometimes have more equity or you sometimes may have more credit. It's yet another tool in the toolkit in a competitive world. And the other thing I would add is that the number of markets that we can invest in and maybe the size of those markets has also grown a lot since the days of Barton Biggs. And so India would be another great example of that.

39:59But the number of European markets that we're active in, we add more countries onto the list. It feels like every couple of years, maybe changes going on in other parts of the world as well. Middle East has been an area that's actually been fairly interesting for actually investing dollars into, which is not something you would have said 10 years ago or 15 years ago in terms of that part of the world. That creates the opportunity set as well as markets become more, not more efficient, but more institutionalized in terms of where things are. So we're wholehearted subscribers to that. If we have this conversation 10 years from now, I think you're going to find more openness to international markets relative to what it's been with this, quote unquote, U.S.

40:38exceptionalism you've had more recently. Yes, I read your white paper, Europe offers compelling investment opportunities. And of course, one of the things we all struggle with is this sort of term eurosolosis, which includes the UK, the lack of growth, the lack of dynamism and dysfunctional capital markets where bank lending has dominated. When you write about and you implement, deploy capital in Europe, how do you think about the priorities versus the opportunities? Well, look, I mean, as a starting point, I think you've had to throw some assumptions out the window in Europe in the last 10 years.

41:12I think investors 10 or 15 years ago would have been more focused on Northern Europe and less focused on Southern Europe. We've become more on a relative basis focused on Southern Europe and less on Northern Europe because the growth is much more in Southern Europe, but the capital is less going to Southern Europe. Sometimes I find these institutional biases die hard. If someone had a bad experience in a deal in Portugal 20 years ago, they may tell you why they don't want to invest in XYZ country. in a country that's true around the world. It's true in certain bankruptcy jurisdictions in the U.S.

41:47as well. And you can say, well, the rules have changed and you can look at the last five or 10 years of history and they've been very good. And that's opportunity, by the way. Not everyone wants to attack an asset class as a result of that. And Europe has been a lower growth environment than the U.S. But to me, and if Howard didn't say this in your podcast with me, he probably should have. Price matters a lot in these things. And so sometimes you can buy cheap and sell cheap and still do really well. And if you buy a good asset, maybe you buy cheap and sell fair priced. You don't need to get a premium price to do well.

42:26Opportunistic credit is not venture capital in terms of the rates of return that we're looking for or multiples of capital that we're looking for in the asset class. And so in the private markets, do you have access to the opportunity? Not everyone's going to have that. If you have access to it, do you really understand what's going on? Do you really understand the dynamics? It's a level fewer of people who are maybe going to have access to that as well. It just narrows the playing field in terms of who can compete. You know, if you're the capital provider, I think that's a really good thing. Got it.

42:53You've mentioned India twice. I saw it in your materials when I went through it. India has been a complicated place for people to invest. I'm talking about international investors. Typically, the equity path has been the one that's been taken. I'm intrigued. just tell us a little bit how you approach the lending space. Well, you know, I'd separate it into two things. On the lending side, there were concrete changes in the rules in India that were made about 10 years ago through their NCLT regime. To the bankruptcy process, they are much more Western style in terms of lenders being able to foreclose on debt, those rules being respected by the courts in a reasonably quick period of time.

43:34So we've had the benefit, if you want to call it that, of being involved in multiple processes, and the processes go on the way you would want it to go. One of my rules of bankruptcy-related investing is sometimes the courts are better than you would think on their face, and sometimes the courts are actually worse than you would think on their face. And so, again, having 40-plus years of expertise in this and looking at hundreds and hundreds of bankruptcy cases across the world, you get a pretty good feel for how things are going to work and when they're going to work. And those have improved in India over a period of time.

44:09So on the credit side, there still is a subset of investors, both international and local, by the way, who were burned under the prior regime, who I think think of things the way they were 10 or 15 years ago versus where they are today. On the money going into equity versus going into debt, I think the reasons of that were much more, the returns on equity in India were potentially quite strong for a longer period of time. You know, international investors, let's say seeking risk, wanted to earn higher returns than those risk dollars. Again, that changes in the credit side, if you look over 25 or 30 years or more recent, they're not older in terms of where they were.

44:51And so as a result of that, people prioritized equity and forgot about credit. There's been much more interest. It's It's still relatively small, but much more interest on the credit side in the last five or six years as these changes have happened. And so, you know, there's, you know, a relatively small community of folks who have been investing there. There's also very high barriers to entry in India in terms of some of the regulatory and tax hoops you need to go through to be an investor there. And that's led to a, you know, good opportunity spent for a small number of folks. I'll go back to my capital chases returns and markets become efficient.

45:24And that market has become more efficient and will continue to become more efficient. But there are still structural reasons why marginal dollars that go into India are much more likely to go into equity than go into credit. Got it. I've got two rapid fire questions as we move to close, which is, what's number one? What's the one or two risks in private markets that people are still underestimating? Well, you know, we mentioned it earlier. I do think people are underestimating the duration risk today. And so the risk is that people just get stuck in low returning funds for a longer period of time, which both chews up capital negatively and eliminates their flexibility.

46:05And for many institutions that have to spend a certain portion of their assets every year on their mission or whatever it is, forces them in a position where they either can't do certain things, so they don't have that liquidity, or they're forced to sell because they need that liquidity. And I think that's a risk that even though people are talking about it is actually far worse than what people think. Clear. And the flip side, if you were a global allocator, you know, with an absolute return mandate, where's the one or two places you would absolutely want to be looking and deploying capital?

46:34Well, you know, I do think doing opportunistic credit in an absolute return strategy has become a little bit old fashioned. There are valid reasons for that, but I think it's a pretty exciting place to be. There are not that many folks who are doing public market investing anymore. To be fair, public market investing, particularly in the United States from the mid 2010s to the COVID crisis was tough. And I think allocators got used to the fact that cycles were going to be steep but short. If you look at the 2015-16 public market cycle or the 2020-21 public market cycle, those were year or two long cycles.

47:13So the viewpoint is, well, hey, aren't all cycles going forward going to be that way? I don't think that's the case. If you go back to earlier in my career, cycles lasted five, six, seven years. They didn't last one or two years. I think it's the dynamic that we're in today. I think we're relatively early into a quite prolonged cycle. It's just going to look completely different because, you know, because of the low covenants and the debt, you just aren't going to have as many bankruptcies. And so, you know, you try to learn from the last crisis, but it turns out the next crisis is always going to look different.

47:46Got it. Three closing questions. Advice for youth. If they're thinking about going into finance versus other things, what would you say to young people? Well, this is probably general advice. It's not necessarily specific to finance. Um, make sure you're going into it because you love it as opposed to going into it because, um, you think you can earn a healthy living or have a good career doing it. What I have found is the people who are the most successful, um, ultimately get to a point where they're not doing their jobs for, um, uh, just compensation and lifestyle. They're doing it for the love of the sport.

48:22And so, you know, I remember early in my career going to ideas dinners, reading Barron's or any number of small publications over the weekend, anything I can get my hands on that was not only finance related, but investing related, wanting to learn about a very wide range of investing, not just what I did. And it was because fundamentally, I really loved doing it for a living. I was very fortunate. Maybe I want this path and not the regulatory law path for that because I don't know if I would have spent my weekends studying regulatory law journals, right, in terms of things along those lines. And so, you know, I'm probably a bigger believer in sampling when people are younger versus having to know exactly what you want to do when you're 16 or 17 years old.

49:07But whatever you do decide, just make sure your heart is really in it. And investment management can be a tough business when your strategy is not in favor or it's not working. What have you learned when the wind is really blowing in your face? Well, you need to understand why. I'm not a believer. Like, there's always something to do somewhere. Like, there's a continuum of investments, and there are going to be investments even when the wind is blowing in your face that are obviously terrible by definition with how you described it, but are also okay or better. And so, you know, you have to start out with as an investment manager, like, what are you offering to your clients?

49:46What are you telling your clients are going to do? Like some of your clients may know that the wind is actually in your in your face. They just want you to do better than the average bear, so to speak, in that period of time. And there's a reason they probably have you in their portfolio and it may be to diversify themselves out of something else that you're doing. So I am a believer in, you know, to some degree sticking with your knitting with this stuff. But if all you say is, well, this is terrible, I don't want to do it. You know, you're not ultimately achieving the goals. And then when these things change, they can change very quickly.

50:14And it can often take a few years for the rest of the world to figure it out. And that's why it's important to always have investors who are in strategies, if that's part of what you're doing, where the wind is in your face, so to speak, because they're going to be the first people to see it. And they're going to have a window where things are exceptionally good in their area because no one is competing with them. And they've got the expertise, and they've got the contacts, and they've got the know-how. And so all asset classes are cyclical. I mean, I'll go back to venture capital. You've had 10-year cycles in venture capital.

50:43You didn't make any money in venture capital in the 1980s, and you made very little to no money in the 2000s, depending upon where you were. But if you stopped doing it for a decade, you missed the great funds at the end of the decade that would have had Uber or Airbnb in them and stuff along those lines. And so I think, again, if you really like your vocation and you like what you're doing, you're going to stick with it even when the times are a little tougher. Finally, investment input. If you could only either watch or read or listen to a piece of investment-related content every day, what's your go-to most important?

51:16Well, I'm going to say Money Maze is number one on the list. No, look, I actually love this podcast, but I've actually gotten into podcasts in general for the level deeper in things, right? So as a basic point, I still get physical newspapers. So we get the FT, Wall Street Journal, New York Times, and Barron's delivered to our house every day. And, you know, in the wider financial press, you get a good chunk of information that's research or investing specific. I'm very fortunate. I've got a very wide variety of investing-related research that's tossed at me from Davidson Kepner analysts all day.

51:54So I have plenty of time to read about investments. And, you know, through investment committee work, I get to learn about other strategies out there that we don't do. But it is fun to get the level deeper. It is fun to get anecdotes and things, especially when you know the markets and you can hear people who you respect and have some knowledge base about. I mean, it was one of the ways I really learned about investing early in my career. You know, I'd watch investors. So, for example, I was in some very large investments that David Tepper was in in Appaloosa very early in my career. and he might have approached some of them differently than we did.

52:29And I would try to reverse engineer what they were doing and why they were doing it and maybe contrast that to things that we were doing in that era. And there's a lot that you can learn from that. I mean, I'm sure a good, I'm more used to American football, but I'll say European football coach is looking at the plays the opposition is running and trying to figure out not only how to stop them, but how to improve their own plays as a result of that. And I think there's a very healthy dynamic of that. But the amount of information that's available on investing online, and it's not limited to podcasts, obviously, it's just so awesome and massive that you could spend your whole life doing that if you wanted to.

53:07And that, of course, that point about data makes me smile because you spotted Liars Poker by Michael Lewis up there on the shelf, also a Princeton alum. I knew him at the LSE, and he's been a guest twice. And, of course, he wrote Moneyball, which was the beginning of that whole new era where data really mattered in analysis rather than the gut feel of the coach and the talent spotter. I've learned a lot today, Tony, and so I want to thank you, first of all, for things I'm taking away from this and your perspective. Number one is the resolution of this private equity and private debt logjam is going to take longer than consensus believes.

53:44Number two is that in a higher return environment, there is more dispersion of returns. and that leads you, number three, to say that you think we are in, starting in the early stages of the golden age of absolute return. And finally, as it pertains to Europe, but not exclusively, you made a really interesting point, which is you can buy cheap and you can sell cheap and still make money and the world's full of opportunities. So Tony, it's been great having you here today. Thank you. Thank you, man. It's a lot of fun, sir.