The Private Credit Unwind Is Coming – Tony Yoseloff

0:00It's really hard to know how long things are going to last in Iran. But I would say that, you know, it's not totally clear to me that we've killed the inflationary impacts of the early 2020s already. And so when you add on to that the potential for having an oil shock, that creates what could be potentially a very disruptive environment. Lending does go through cycles. There's no free lunch in this stuff. And, you know, my truisms of investing are that capital chases returns and markets become efficient over time and just a tremendous amount of capital flow into this asset class, specifically direct corporate lending.

0:39And, you know, that's just starting to catch up. True default rates in these markets are already five or six percent and have been the last couple of years. That's nothing to do with oil, nothing to do with Iran, nothing to do with, you know, some of the software loans that are getting a lot of press today. It's just because, you know, companies themselves have had a really hard time adjusting to higher interest rate environment. We sit at Davidson Kempner between public and private markets. We have very active businesses in both. And, you know, one of the nice things about public market investing is, you know, the market tells you every day what things are worth.

1:15Welcome to the Master Investor Podcast with me, Wilfrid Frost, where we celebrate and learn from the success of the greatest investors, politicians and business leaders in the world, giving you, our listeners, the edge. The Master Investor Podcast is sponsored by BNY Investments, LSEG and Interactive Brokers. Please do remember the views expressed in this podcast are for general information purposes only. Nothing in the podcast constitutes a financial promotion, investment advice, or a personal recommendation. More on that in the show notes. My guest today is Tony Yosiloff, the Executive Managing Member and CIO of Davidson Kempner, one of the most enduring and successful alternative asset hedge funds in the world, some$40 billion in assets under management, predominantly in opportunistic credit and event-driven investment.

2:13Tony, it is great to have you with us. Welcome to the Master Investor Podcast. Thank you so much, Wolf. It's really great to be here with you today. Tell us about the background of the firm, because it's not typical to some of the funds and CIOs we have on? So Davidson Kempner has been in business since 1983. We were originally the family office of Marvin Davidson. Marvin Davidson was a senior executive at Bear Stearns in the 1960s and 1970s. And when he retired, he wanted to run his money in a way that would both generate attractive returns, but also be uncorrelated to markets. Marvin was an expert in arbitrage strategies from Bear Stearns, and he was joined a few years later with Tom Kempner.

2:57Tom Kempner came from a storied New York banking family. And Tom had a real expertise in trading troubled bonds from his time at Goldman Sachs and his time working with his family. And that became the origins of Davidson Kempner. We started managing money for people on the outside in 1987. And so now we've been in business for 43 years. And when I say opportunistic credit, event-driven investing, is that the right framing of the focus of what you do? And for the uninitiated, Tell us what that is. Yeah, I mean, those terms mean different things to different people. On the credit side, you know, we're best known for investing in stressed and distressed companies, but it's also providing growth capital for companies with maybe imperfect balance sheets or relatively new stories.

3:44And we do that globally. So we're investing in markets throughout the globe. Event-driven investing, again, can also mean different things to different people. we're really referring to the macro events that are happening to the individual companies and not the macro events that are happening in markets. So that could be something as definitive as a merger, but it also could be much more subtle things. Companies selling businesses, companies reorganizing businesses, different larger events happening to companies, etc. And again, that business for us is global as well. I want to hit now a couple of the big current environment macro factors and how it informs what you guys are doing before we kind of dive into your way of investing again in more detail in a moment.

4:27But the first one is Iran, oil prices and what it might do to inflation. We've been speaking for a number of months now building up to this. And I was struck even before this latest conflict broke out, you were comparing the current environment to the 1970s. Clearly, we'd had glimpses of that in the last year, particularly with precious metals taking off. But we hadn't really seen the oil price spike yet. Tell me why you had been thinking that this next decade might resemble the 1970s anyway. And I guess with recent events, you must be increasing your conviction in that. Well, I mean, I think there are really two pertinent decades or periods of time that you could look at in comparison to the current markets.

5:15One is the 1970s and one is the very early 2000s, which would have been the popping of Internet bubble 1.0. And I think there are some similarities with one and some similarities with the other. You know, I'd start out with some basic factors, the first of which is market concentration. So you've had incredible market concentration in equities with a handful of stocks really leading the charge. That tends to be synonymous. Now, correlation is not causation, but that tends to be synonymous with, you know, high points in markets. And you can see that in the, you know, limited breadth of, let's say, the S &P in both the 1970s with the nifty 50 stocks that were really leading the charge of that era or in the early 2000s.

5:58There also are, you know, very long term implications of rate shocks and rate hikes. And you saw that in different ways. The 1970s decade, you know, produced three different attempts by the Fed to kill inflation by raising rates. Each one was cut prematurely. Each one led to even higher rates, which led to kind of the legendary Paul Volcker period of time in the Fed in the late 1970s, where you had short-term interest rates in the low teens in terms of U.S. Treasuries, AAA-type debt. The end of the 1990s decade was sort of the end of a decade-long period of inflationary environment in the U.S.

6:42with a risk-free rate of 5 % or 6 % there. And it just took a very long time for that to kind of burn off in terms of the implications. You know, with where we are today, it's really hard to know how long things are going to last in Iran. But I would say that, you know, it's not totally clear to me that we've killed the inflationary impacts of the early 2020s already. And so when you add on to that the potential for having an oil shock, that creates what could be potentially a very disruptive environment. I wouldn't bank on that, but it's certainly in the realm of possibility. I do think that the Western world is still adjusting to higher interest rates going back to 2021, 2022.

7:29It's not the rate of return for treasuries that things have reached. That's the problem by itself. If you go backwards, the 100-year history of the 10-year treasury in the United States has been between 4 % and 5 % on average. And so having a risk-free rate of around 4 % is sort of an average number over a very long period of time. The hard point was the 550 basis point rise in short-term rates that you had in the 2021-22 era. And the steepness with which that happened over a 16-month period, that was almost unprecedented if you go back over very long periods of time. And so, again, people get used to certain things, 15%, 0 % interest rates.

8:12People got used to that in the markets. They made their business decisions or otherwise based upon that. That wasn't totally irrational given the time period. People maybe thought we were going to be in an environment more like Japan, where you had very, very long-term, short-term rates. That obviously didn't materialize, and we're still digesting all the impacts of this. I mean, one thing I would note, because it's a little bit counterintuitive, is you actually did make money most years in fixed income in the 1970s, despite having those rate hikes in that period of time. It was a very hard time for asset classes other than commodities, but fixed income generally did okay.

8:45And the reason is you eventually built up enough coupon with higher rates that it made up for bond principal losses you would take in the short term on rates going up. So it was very, very tough if you were an equity investor in that period of time. I mean, Warren Buffett famously made his career buying stocks very cheaply in the 1972 to 74 downdraft, but there were asset classes you could do okay. So in terms of just where we are now, do you think that we have started, even before the Iran war, started cutting interest rates too soon? And I guess what are the implications of if that reverses or pauses?

9:23I mean, it's interesting to see Australia actually hiked rates today. Obviously, that's an Iran war factor. But do you expect us to have to go back up again? And what are the big implications of that? I think it's in the range of possibility that that could be an outcome. That wouldn't be my prediction for 2026, but I think it's in the range of possibilities that could be an outcome. And I think the implication of that would likely be recessionary in the U.S. I mean, I would note it's been a very long time since we've had a recession in the United States, and I think that would be a tough one to swallow.

9:59I mean, one of the things I would note if you look at interest rates is just the curve has gotten a lot steeper in the last couple of years. You know, there's obviously tremendous concern worldwide about the fiscal deficits that we have in the United States. On the other hand, you know, it is the best alternative that's out there. And so you've had this trading range of 10-year treasuries, which is kind of what I look at as a bellwether, between 4 % and 5%. You know, cutting short-term rates will be good for a number of folks. The people it's by far the best for is the United States Treasury, because there's a disproportionate amount of U.S.

10:34debt that's five years and in in terms of where rates are. But if inflation does wind up being even in the threes, it doesn't need to go back to the levels it was at in 2021, 22. Even if it winds up being in the threes, I think it's going to be a hard environment for the Fed to stand pat. And again, I don't think that's going to be a 2026 issue, but I think it's certainly something that's in the real realm of possibility. And just quickly on oil prices, if they stay at this level and it stays for weeks or months, is that a real problem or is this level palatable? I think in the short term, it would be OK.

11:14And so if the definition is weeks and months, like a few months, let's say even going into the summer driving season in the United States, Like, I think that would be OK because people might see a light at the end of the tunnel in terms of where things were. And clearly there was a trend line downward in oil prices, which was probably deservedly so in the three or four years prior to this. But, you know, the problem is that weeks and months can become months and years before you know it. I mean, it's funny, I was thinking about this or maybe not so funny in the covid context where there were, you know, events that we thought that were supposed to happen spring of 2020 that might happen fall of 2020.

11:51and happened in 2022 or 23, because the years go by quicker than you think. And so if months become years or a year, that's just going to be a lot harder. And there just aren't easy answers to what's going on right now. There may prove to be an answer, but there's not easy answers.

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12:39the other big current macro related topic i wanted to touch on is is private credit and i guess the unwind of private credit that we're starting to see first question on that are you surprised to see this unwind that that's kind of picked up a lot more coverage and pace in the last couple of months um i'm not surprised to see it and you know this is an asset class that i followed for close to 30 years at this point. So I have a lot of experience with it. And I would give a couple of answers to that. First of all, we've said repeatedly over the last few years that we think this is a mid... And by private credit, I want to be clear, I'm talking about direct corporate lending.

13:17I think people use that term to represent different things. And I'm not sure why. I don't believe all parts of private credit are created equal. I think there are some parts of it that might be better positioned than others. But in the direct corporate lending space, which is where by far the largest amount of capital has flown to. You know, we've believed this was a mid-single-digit asset class in terms of expected rate of return for a very long time. There was a brief period of time in the early 2020s where it was marketed and described as a, you know, double-digit asset class, but we just don't think that's the long-term returns on this.

13:49You know, if you look at where true default rates have been the last couple of years and you include, you know, what are called liability management exercises in public markets, which is when companies go to their lenders and say, we don't want to pay you back in full. Sometimes it's referred to by the press as creditor-on-creditor violence in that case. And the same thing happens in private markets, too. It's just when companies go on a coupon holiday, so to speak, with the agreement of their lenders. But true default rates in these markets are already 5 % or 6 % and have been the last couple of years.

14:22That's nothing to do with oil, nothing to do with Iran, nothing to do with some of the software loans that are getting a lot of press today. It's just because, you know, companies themselves have had a really hard time adjusting to higher interest rate environment. A lot of these companies would be the lower, you know, quartile or half of companies that are out there. It's not necessarily some of the strength of some of the big public market companies that you have in terms of robustness of their business. And so you've got a lot of companies with limited to no growth over the last four or five years in their earnings power.

14:53And then, you know, Private equity firms in particular, which are by far the biggest borrower segment of this group, paid really high prices for businesses in the 2019 to 2021-22 context. And so you take all those things together, and you've got a story of default rates being much higher than were advertised. And then there's two things that happen that hurt you as a lender. One is that people don't pay you back, and number two is what you get back on the loans where you don't get paid back in full. And those rates have been coming down for 15 years. The recovery on first lien debt last year was 36 cents on the dollar.

15:26When I started my career in the late 1990s, the rule of thumb was 70 to 80 cents on the dollar. That's been a steady decline in what you get back on loans going over 15 years. It goes back to pre-GFC, but it really accelerated pre-GFC. And if you want to put this all in historic context, Wolf, if you go to the 2000s decade, the average default rate on leveraged loans was 5 % to 6%. So it's not like this is new. You know, again, what was new is you had a 15 year period of time with zero percent interest rates. And during that period of time, you know, borrowers could continue to roll over their their debt.

16:01And so lenders saw very few losses. There's this, you know, great term in the lending world, a rolling loan gathers no loss. And so, you know, if someone else is willing to take you out of par, you get your par. And it doesn't really matter what happens to them eventually. And, you know, that comes home to that comes home to roost. And so I do think that the institutional community had largely figured this out in the last couple of years. I think there had been a dramatic slowdown in institutional interest in the asset class. And I think the leader in the clubhouse, so to speak, the last few years has been the retail asset class or retail investors in terms of getting into this asset class.

16:41And, you know, obviously, you know, we've all seen the headlines and that's starting to reverse itself a bit. But none of this is surprising to me. Lending does go through cycles. There's no free lunch in this stuff. And my truisms of investing are that capital chases returns and markets become efficient over time. And just a tremendous amount of capital flow into this asset class, specifically direct corporate lending. And that's just starting to catch up with where rates are in the asset class. I want to ask about your exposure and even the opportunities, in fact, that might come from it in a moment.

17:12But just quickly, I mean, there are some massive players in this, like Blackstone. and they've been getting creative, perhaps clever, with their private credit fund. And then there's a lot of smaller players, the BDCs as well. Are they all exposed? Are they all facing significant trouble? Or is it going to be relatively selective? So, I mean, I don't want to really comment on any one firm in particular. So I'll give a more general answer to it. So, you know, first of all, in terms of the lending class, if you were doing direct corporate lending in the last five years and you're doing it in any scale, it would have been kind of hard to hide, you know, from some of these problems because we think the default rates are market wide.

18:00It's not necessarily just one asset class. I would say in the software space in particular, you know, that's one where there are going to be some firms that have more of it and some firms that have less of it. But there's going to be virtually no firms that have none of it or almost none of it. And the reason for that is that software lending was over 30 percent of this asset class. If you look at advertised numbers, it's probably closer to 21 or 22 percent. But then if you look a level underneath the hood and, you know, there's a rule in finance, you're always supposed to read the footnotes. Right.

18:30And so there's a portion of that with this. If you looked at business services companies, right, a lot of those were effectively software businesses. If you looked at health care companies, a lot of those were effectively health care software companies. So there are companies selling software to the health care industry or hospitals. And if you looked at technology companies, a lot of those weren't really hard technology companies. They were software companies. And when you take all those numbers and aggregate them together, you know, it's 30 percent, right? It's almost one in three loans were a software loan.

19:00So, you know, if you were in the business in any scale, the chances are you had some software lending. You might have been less than 30 percent and therefore there were funds that were more than 30 percent because obviously there were some lenders with a strategy of only doing this sort of lending or mostly doing this sort of lending. And it's not to say that every loan is going to be bad or every loan is going to not have a full recovery on it at the end of the day. There just are, you know, obvious headwinds when you've got coding agents out there that can do the work of what hundreds of coders used to do over a very long period of time very, very quickly.

19:32You know, technological change is a theme in markets, both equity markets and credit markets for a long period of time. I mean, you know, because I happen to have started my career in the late 1990s, you know, I saw the Internet systematically destroy almost every business model over a 30 year period. You know, some of them ultimately rebounded and the business models became stronger, but many of them, you know, changed and weren't as profitable or weren't as good. And, you know, it does appear that AI is going to have some of these same implications as well. And so I do think some firms will be better prepared for this and some firms will be worse prepared.

20:05But the bigger you are, the more likely it is that you have some market concentration in areas that would have been 30 percent. Because, like, how would you have avoided that in scaling your business? So it sounds like you're implying that you've avoided exposure here. How have you done that? Well, we don't have zero software exposure, so I don't want to represent that. I'd say we have very limited exposure to software on the credit side of our business. We do have equities businesses and convert businesses and other things that may have different positions. I look at recovery rates in these businesses, right?

20:39And, you know, my experience over a very long period of time is, you know, we've been involved in the liquidation of many technology businesses. I mean, one of the things that I cut my teeth on very early in my career is, you know, we were the largest creditor, one of the largest creditor of some names that have long been forgotten to the dust heap, but would have been some of the big fiber names of the early 2000s. So these are names like PSINet or X's Communications. And there are other ones that we were involved with that ultimately went on to be OK, but after very long periods of time. And, you know, when there's obsolescence, the recovery rates tend to be worse.

21:17And the stories that people tell as to how you're going to get your money back tend not to work. So, for example, one of the things that you hear in rapidly declining businesses is there's an embedded customer base. And so the business will shrink and therefore you'll be okay as a creditor. Well, the business almost always shrinks more rapidly than you can work with that embedded customer base. And that embedded customer base is probably having the same issues with your product than the customer base that's left you. Right. So that tends not to not to work. These businesses have limited to no hard asset value.

21:51And then, you know, another way that you actually can be successful in getting most or all of your money back as a stressed creditor is if there's a good business and a bad business, because you can shut the bad business and you can kind of reorganize around the good business. And perhaps the good business is good enough to be helpful to get most or all of your money back as a creditor. It may not be as an equity holder, but it is as a creditor. You know, most of these software businesses are a business. They're not a good business and a bad business put together. There are some, but it's not the majority of them.

22:21And so if things go bad, they go really bad. I mean, again, simplistically, when you're buying debt, whether you're buying it in the primary market and you're paying around par, whether you're buying it in the secondary market, you're typically capped out at par on the upside and you own all the downside of the instrument. And so you have to really be thinking about what can go wrong. And again, from my experience in many other businesses over very long periods of time, you know, when things really start to go south, like the value is not there. I mean, I'll point to one that's probably near and dear to both of our hearts, which is newspapers.

22:55Like there were at least newspapers that had tremendously valuable real estate or pieces of sports teams that could get sold off other ancillary assets when those businesses, you know, ultimately went bad in the early to mid 2000s. that doesn't exist for most software companies in the same way. And just finally on this topic, I mean, to what extent is this now? I mean, you look at the S &P 500. I know you guys don't just buy indices or whatever, but we're only down three and a half percent this month when we've had the war breakout. We've had issues around private credit flag up again. I mean, have these companies come clean on the scale of the troubles?

23:34Have they marked market or not? Well, I mean, I would separate what's happening maybe in the S &P 500, which in theory is probably the 500 largest best companies in the United States. That's not entirely true. There are a handful of giants in the private markets as well. But the super majority of those companies would be the best and the brightest that the US has to offer in that area. And so I'd make two comments. I mean, the first of which is there's tremendous dispersion underneath the hood in the S &P in terms of single stock performance. And so it is absolutely true that the S &P is at or near all-time highs.

24:09What's really changed is where that performance is coming from over the last year. You know, you had a long period of time where basically it was a relatively small number of tech stocks, you know, culminating in the magnificent seven stocks plus or minus that were really driving market performance. Those stocks have not done well collectively over the last 12 months. Everything else has done reasonably well. And so if you were to look at a comparison of the S &P 493, say, so the other 493 companies compared to the MAG-7, it's done a lot better. And so if you look at measures of single stock dispersion, right, so how individual stocks behave, it's been off the charts high on a 30-year look back.