How Oaktree's Head of Sourcing Finds the Next Great Deal

25:27Sometimes, sometimes deals do well because the management team is very good and very articulate. And I knew this deal would struggle at a bank. And so when it was hung, which means the bank had to fund it. They got stuck with it. They got stuck with it. I called in and I said, hey, sorry, but I'll buy 50 million at 90. Okay. Right? Oh, gosh, no, at 90. Wow, that's a deep discount. Da, da, da, da, da. I said, well, you know, I think as you now realize that business is not, It's a little tricky business. And it was a public to a private. So a private equity firm was taking a public company and making it private.

26:03And even though it was a declining margin business, there was a view that the public company expenses were high. So you could sort of map a scenario where over 12 months, they were going to cut some of the public company costs and create a more efficient, which would create more EBITDA. Yeah. Right? So they sold it to us. So now I'm a top five lender, right? With the right response or you have the right relationship, right? Well, sponsor, which, you know, they're meant to be opportunistic too. Cap structure, EBITDA grew, cap structure looked good. So they wanted to do a dividend. Now, again, in a negotiation, if you're doing a dividend, that means you're putting more debt on my capital structure.

26:46Yeah. Right? That's money that could go to you. That's money that could go to anybody but them, right? Yeah. And so, you know, the job of a sponsor at that moment is to call the top five lenders and say, hey, I'm doing a dividend deal. And they take me from violently upset to mildly annoyed. That's the job. Yeah. So this sponsor did not call us on that dividend deal. And so now I have a I'm in a unique situation. They went to other lenders and got the 51 percent to do the deal. And I felt some kind of way about that. Some kind of way. Some kind of way. And so I proceeded to try to figure out why folks would agree to this dividend deal.

27:24And so I called the market and the sponsor sort of said, you know, he calls me and he says, Millwood, I hear you're working against me on my dividend deal. I said, well, that's not actually true because you didn't call me when you launched it. So he said, but I thought we had a good relationship. I said, we do. I thought so too. But you didn't call me. All right. And so long story short, the dividend didn't go through. Right. And so then we changed the structure of the dividend to allow we shrunk the size of the dividend. We changed the original issue discount. And I told the sponsor, I said, look, unfortunately, I'm going to sell the position when this closes.

28:02And the point of that story is sometimes it's life's too short and not all not all relationships are meant to go on forever. We still talk. I'm still a good friend. He's still a good friend. But we haven't done a lot together since then because sometimes, you know, in a negotiation, if you don't see eye to eye and that deal worked out, what happens if it doesn't work out? Yeah. Right? So sometimes you're managing relationships to keep and sometimes you're managing relationships to not do on a business side. But you always want to be friendly in this market because you're usually one person away from somebody that matters in the business.

28:41Actually, since we're on this point, that strikes me as very savvy and very wise and like probably a lesson many of us should learn in many realms that sometimes it's OK to take the L or let a proposal fall apart because life is long and other things happen at some point. And we have listeners who are in college or young and they think about, you know, career trajectories, et cetera. I'm curious just from your perspective, this is probably a sort of attitude that you would hope the people who work for you cultivate, internalize, so to speak. How do you recognize who has that? And like when you think about like people that you want on your team, are you able to sort of like build intuitions about, you know, the people who can think that way?

29:27Yeah. So good question. So I would say on my team, everyone is uniquely different and everyone is exceptional at something and very good at everything else. And I think where you make a mistake in building teams, especially in our business, is you try to find someone who can be exceptional in more than one thing. So I'll tell you a good story. So when I was first starting out, I would fly to Dallas, Texas, and I would meet with folks in Texas. And I thought I was a pretty charming, knowledgeable person on the markets. And everyone in Texas was friendly. But what I figured out was by the time the deals made it to me in New York, everyone in Texas had already passed.

30:06So it was almost like wrong-way risk. And so – Explain that. Yeah. Why was that happening? Well, because you're in Texas, right? It's a different culture, different market in New York. And in some markets, folks want to do business with folks they may see on the weekend or see in the gym or, you know. And so it's more of a that person sits in New York. They don't really know me, right? Yeah, yeah. So but if people in Texas didn't really like the deal, then you call the people in New York. Oh. So I decided that I needed to put someone in Texas. So how do you hire people, right? So this is for your young audience.

30:47So I went to a conference, and he was kind of managing the room really nicely. So I gave him my business card. I said, hey, we'd love to spend some time with you. So I called him, and we set up two days of meetings. Well, he didn't realize I was actually interviewing him for two days because everyone says they have great relationships, right? Everyone says, oh, yeah, I've got the best relationship, da-da-da-da-da. But how do you actually test that? So I spent two days with this person. And look, high school football matters in Texas. I didn't play high school football. I played high school baseball.

31:16This person plays high school football. And so you put someone in that territory that understands the local culture. And what we're trying to do is have a hub-and-spoke origination model where we have a global firm, but we try to talk on a more regional and local level. and that's what I think makes our sourcing origination a little bit different and again people matter in this business and again the goal is to get the first call and the last call that person may spend a lot of time you know going to events spending time with the families yeah and and ultimately what you want folks to do is to show you deals because they trust you and it's still a trust me business

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33:35Paid for by Public Investing. All investing involves the risk of loss, including loss of principal. Brokerage services for U.S.-listed registered securities, options and bonds, and a self-directed account are offered by Public Investing, Inc., member FINRA and SIPC. Crypto trading provided by Backed Crypto Solutions, LLC. Complete disclosures available at public.com. slash disclosure. One thing I wanted to ask you, just going back to something you said about the management of a particular company being good. In credit, we've spoken about this on the podcast before, but we tend to think about it as avoiding losers, right?

34:05Whereas equities are more about finding the winners. How would love you said that? So I guess my question is like, when you're looking at a particular deal, do you feel that you're making a bet on that business? Or is it just about looking at the numbers and making sure that you're not going to lose out? They're unlikely to screw it up. Yeah. So interesting enough, what we're trying to do in a diligence process is figure out where there may be holes in that investment. We did one deal with a counterparty that we required them to switch to CFO. Just because the questions, it took too long to answer.

34:41Like if I ask you, how many days does it take you to close your books? What percentage of that is manual versus automated? What do your management letters say in the auditor? You know, those types of questions, if you have to think about them or you say, I'll come back to you as a CFO, that would be concerning. So, you know, our job is to protect our investors. That's our job. And what we're trying to do is make sure we understand the investment and no one bats a thousand, right? If you look at the top 10 hitters in Major League Baseball, they strike out as much as they hit. So, you know, our job is to avoid losers, like you said, and we have to manage that through a process.

35:19Can you say actually a little more? I thought that was really interesting about some of the questions that you asked and the idea like why can't the CFO just quickly answer how long it takes to lose their – You would think that would be an easy – yeah. I'm always surprised also just generally there's a bit of a tangent that even in 2024 with like all the computer and accounting systems that like fraud still happens, that there are still ways – or companies like we have a material weakness and we're going to have to – I'm always a little surprised that that can even still happen. I'm curious like how you like – this world of things just being wrong are ambiguous at companies.

35:50I'd love to hear you talk more about that. When you buy a business as a platform and then you then buy successive businesses, more than likely they didn't have all the same financial system. Oh, yeah, yeah. And the integration process, depending on how quickly you want to grow it, drives how long you actually integrate. And so what happens sometimes is you don't fully integrate these businesses and systems. If you go back to failures of businesses in our market, SAP integration is a big sort of point of contention. And so businesses, you focus on risk that you see time and time. So fraud, fraud, you know, there was a water business that was, you know, that was fraud, fraudulent that, you know, some banks lost a lot of money.

36:34You know, if you go back to like Collins and Aikman, which was an LBO a long time ago, there was some fraud. And you could see what you what you're doing in a diligence process. You are looking for sort of what I call inherent weaknesses in the information you get back. And management letters, which the auditors produce, is a good document that sort of highlights the risk of accounting systems, financial systems. And that's a pretty – systems tends to be a big driver of sort of integration issues. So this isn't necessarily fraud, but you just reminded me of ad backs and deals and adjusted earnings and things that can be inflated to make a transaction look a lot better than it actually is.

37:17Yeah. The last time I remember writing about this was, I guess, gosh, five or six years ago. And the feeling back then was that there was more sketchy stuff happening on the valuation side of credit deals. Is that still the case or has that been your observation over the years? Well, so the add backs, it's an assumption and it's an ask to get credit for something that may happen in the future. Right. Or it's saying something's happened previously that hasn't fully been flown through the financial statements and we want to get credit or we don't want it to affect our earnings. Every deal has adjustments.

37:54OK, so just start with the premise that adjusted EBITDA will exist. And part of our job is to trust our partners that they're adjusting the right things. What happens is if you watch the financial statements over time, sometimes the adjustments never go away. right and then you start to say okay this is recurring non-recurring right we we did a deal for a sponsor and we were and it was near year end and the sponsor is going through each line item of what they wanted to add back and you know what i said wow we could we could go through this for three days right explaining why they had that i said you know what you can add back five million call it whatever you want right yeah so at the end of the day what we're trying to do is understand in the rationale for the ad back.

38:42In a market like today, the problem is the rationale isn't fully explained all the time. And the amount of time you want to add it back is kind of almost infinite. So you start to say, okay, and the sponsor's perspective would be I'm paying for that, right? Because I'm paying off that adjusted EBITDA, so you should leverage against that. The counter would be I'm capped upside, right? I'm capped at par. And if you go back to 07, a lot of the ad bags in some of the large LBOs never truly came to fruition. So if you take cap structures that were leveraged seven times, if you're adding back 100 million, that's 700 million more debt that if the 100 million never comes through, at some level you could be over levered.

39:28So that's why you have to look at ad bags. And in the one notion, folks say documents are loose. Well, I would argue it's about asset selection, right? A document is not going to help you if you just underwrote the wrong asset. At the same time, a document, if you're doing well and I'm not letting you lend more, what do you think I'm going to do if you're doing well? I'm probably going to figure out a way to fix the document to allow you to lend more. So I think part of our business, you're right on at-bats. But, you know, CovLite, the market is mostly CovLite. And even when you think about structures with a covenant, a lot of times if you actually hit that covenant, it's unclear the business is a going concern at that point.

40:13If you need the document to save you, then you've already got a problem. Yeah. Well, since we're actually talking about documents and we have done a recent episode about so-called creditor on creditor violence and how that works, et cetera. One thing that came up with that and I'm also curious about is like legal expenses and detail, you know, every comma and all that stuff in these documents. I'm just curious, like over the course of your career, how much have you seen, perhaps to the point that it changes your expected return on investment, legal costs and the sort of rising lawyer fees, et cetera, to check those documents, regardless of how many covenants they have in them?

41:01And have you seen an evolution over time since you've just been in the business of how much of a deal resources end up going to the legal side? Yeah. How much do the lawyers bill you every year? And what have you seen? So while I said I'm going to now counter myself. OK. While I said the document won't save you in a deal, it's very important you have a document that sort of expressly documents what it is, the intentions of the transaction. Yeah. And it's very good to have governance in the document, right? So if you just think about public versus private markets, in a public market situation, you're given two to three days to review a 300-pay legal document.

41:42Now, if the deal is going very, very well, arguably there isn't a lot of opportunity for you to push back on the document, right? So you kind of take the document as is in the public market. And the issue with that, there's a lot of, and you said credit and credit balance, but there are a lot of opportunities for you to take assets out of a restricted group, create new co and lend against that and take value away from existing lenders. I think one thing that private credit is very good at and is focused on that part of the document, we've been very firm on making sure that the ability to take assets out and create new assets or new financing or new capital, we've limited that quite a bit in private credit.

42:23But I will tell you, lawyers would argue inflation is real for them too, right? Yeah, sure, sure. So, you know, and a lot of that deal cost gets kind of, you know, born at the beginning. But yeah, lawyers, but you need lawyers, right? You need them. You know, there's two reasons why a deal usually gets hung up. It's usually a legal or tax reason on the M &A side, on the financing side. And so lawyers are an important part of of our process. And we spend a lot of time making sure we have the right counsel who can understand and be able to move with us. If this goes sideways, we want to make sure your bankruptcy and attorneys are really good.

43:01We want to make sure that you are put, you know, if you're thinking about biotech or something where IP is important, how do we make sure that IP, you can't over-license it? There's a lot of nuances in the document that we find lawyers are very valuable in our process. So I just have one more question. But, you know, you've had such a long history in this market and you've worked on so many interesting transactions. What deal are you most proud of? hmm so when i was doing lbo's it's almost like you're watching the company and the sponsor get married and you sit in the middle of that marriage and you're kind of playing consultant and all of my deals i still talk to the ceos of those deals because you get to know these people you're on planes with them for 10 days you know i know some of the quirks of some ceos you know You just get to know people.

43:54When I was doing the buyout, when Hughes spun out DirecTV, Roxanne Austin was a rock star, a female CEO running DirecTV, a very profitable business, and really get to know interesting people. So I would tell you all the deals I'm pretty proud of. There's probably one that was a bit of a disaster that we used to say if you made one bond payment. Wait. Tell us about the deal that you're least proud of. Yeah. So that was probably the deal. It's actually just a more interesting question, but nobody really wants to ask that first. Yeah. That's the more interesting question. That deal was hard. That deal was hard.

44:26It made one coupon payment and filed. Are you going to tell us what it is? No. Okay. I want to protect those involved. Okay. Yeah. But good question. Okay. And I think, you know, so I've done a lot of deals and most of them I'm pretty happy about. All right. I think you mentioned you take, all right, you want to be the first call. Yes. And to some extent being the first call is some combination of the ability to give decent pricing and also just being a likable guy that people want to talk to about their family. But I think you said you take 20 calls and you maybe take – So what you're saying – what I'm saying is out of 20 calls I get, the last two are the most interesting.

45:07So how do you actually engage 18 times and it goes nowhere? Yeah. But like is there a minimum – like you have to say yes to – you can't say no forever. Otherwise, at some point, you'll no longer be the first call, right? Yeah. I might like talking to Tracy a lot. But if she never like in the end wants to consummate the deal, eventually she's no longer going to be my first call. Well, it's how you say no. OK. So talk to us about saying no but still maintaining the first call. Sometimes we don't say no. We say here's how we can get to a yes. OK. Right? So sometimes you give a path to a yes. All right.

45:38Sometimes in a market like we're in today, it's not clear that someone takes my no offensively. There's a lot of capital. So it's easier to say no in this market than a market where there's not a lot of capital. And generally, we may say no. It may be a concentration issue. Maybe we feel like we have too much of that type of risk on our books. It could be an attachment issue, like leverage or attachment could be a problem. It could be that we had an issue with a similar business and maybe our LPs are fatigued in that type of space and we don't want to sort of bring it up again. There are a host of reasons why we may say no.

46:16We may not get there fast enough. That happens in this market. But generally, I think we're a pretty quick study and what we are very good at is we do exactly what we say we're going to do. So if we put something on paper, we're going to stand by that. And I think that goes a long ways. And I think if people say, well, why do they call Oaktree? I think we price risk, right? So in some markets, that's a real big competitive advantage. And I think we don't BS people. We say what we can do. We do what we say. And that's it. And so sometimes our answer is, yeah, we like it, but we don't love it. But if the sponsor or somebody is able to say, well, Oaktree's involved, right?

46:56That gives credibility to the deal. and we can help them get it done by saying we're involved, but we may not be the anchor. We may not lead it. And when you're managing a size capital, we need to write$300 million to$500 million checks on most situations. So we're always looking at the biggest deals with the largest sponsors. Generally, those are safer plays than the lower middle markets. So we think there's less competition when there's only seven of us that can write large checks versus in smaller deals, Hundreds of folks can write small tax. I have one more question, actually. I just remembered.

47:33But you mentioned earlier that you want to be friendly with everyone, including the banks that you're ostensibly in competition with. One thing that's been happening recently, it seems, is that a lot of deals that were originally done in the private credit market are getting refinanced in the public market by banks. Yeah. So first of all, why is that happening? And then secondly, like, is that a concern for someone like Oaktree? That is great. Like if we can be on two or three year interim capital in most situations, that's good. The reason why they're going back to the public market is there's a spread between public and private.

48:11So there's a cost reduction element. And then for the sponsor is more flexibility. Private credit is not meant to be the most flexible. It's the most efficient, but it's not necessarily the most flexible. And if I can create and institutionalize and have a broader investor base, right, sometimes I can get more things done if a lot more people own it at very small sizes versus five or six owning at a chunky size. So it's actually you want a healthy market, public and private, right? And when most folks say, oh, you're losing deals to public, I'm like, well, I probably should have gone to public market anyway, right?

48:48It's rated. It's an existing issuer. It's been in the public markets. It's just staying in public markets. You know, if you think about the private credit market, we're$1.7,$1.8 trillion going to probably$3 trillion. There's ABF, asset-based finance, which is a new phenomenon, which isn't really new, right? GE Capital was a large ABF lender. But there's$3 trillion of dry powder at private equity firms. There's enough for us all to do and be happy. All right, Millwood Hobbs, thank you so much for coming on All Thoughts. That was fantastic. That was so good. Thank you. Thank you so much. I'm so glad we made this happen.

49:36Joe, that was so much fun. That was an unusually fun and good episode, even though all of our guests are the perfect guests. But, you know, I really like and I think we should do more about talking with the people whose job it is to be nice to people and hang out with people. Yeah, because that's like an element. We could learn a lot. Yeah, we could. But that's like an element in finance that's still, you know, like I said, we talk to a lot of screen people and I'm a screen people. I'm glad that there are still parts of the industry where there's a big role for likable people who can maintain relationships and stuff like that.

50:11And play golf. But that's part of being human, right? Don't you have a whole song with the title, like, All My Friends Are Online or something like that? Yeah, All My Friends Are On My Phone. Yeah. Yeah, like, I want to know more people who have friends who aren't on their phone. Who have friends IRL. Yeah. All right. There's a lot to pull out of that. I did think, like, Millwood's early point about banks being in the business of, like, pricing and moving risk very quickly was a good one. Because I think like that's kind of a fundamental difference with private credit. That was really interesting.

50:46I also it was really interesting hearing him talk about the tensions that emerge because you want to be the first call and you want to have a reputation for at least saying yes 10 percent of the time or something like that. Yeah. With the demands of the actual PM who doesn't care about all the times you have to say no. So, you know, I think this is probably a sort of asymmetry that comes up in a lot of sales based businesses, right? Where you have some salesperson and their job is to hit a commission or something like that. And then you have like a product manager who's like, no, you can't price it at this or we can't move the product this fast.

51:22This is just sort of like an interesting dynamic that emerges in all businesses. And I really enjoyed hearing him describe how he negotiates that implicitly and explicitly. Negotiations, because a lot of these deals involve like so many different entities who are all coming at it from a different angle with a different incentive. Yeah, so much there. We'll have to talk to Melody. Yeah, we should. All right. Shall we leave it there? Let's leave it there. This has been another episode of the Odd Thoughts podcast. I'm Tracy Allaway. You can follow me at Tracy Allaway. And I'm Joe Weisenthal. You can follow me at The Stalwart.

51:53Follow our producers, Carmen Rodriguez at Carmen Armin, Dashiell Bennett at Dashbot, and Kale Brooks at Kale Brooks. Thank you to our producer, Moses Andam. For more OddLots content, go to Bloomberg.com slash OddLots. We have transcripts, a blog, and a daily newsletter. You can chat about all of these topics 24-7 in our Discord, discord.gg slash OddLots. And if you enjoy OddLots, if you like it when we talk about how to source deals in the private credit market, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, in addition to getting our daily newsletter, you can also listen to all of our episodes absolutely ad-free.

52:33All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening.

52:53Thank you.

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