Invest Like the Best with Patrick O'Shaughnessy

Scott Goodwin - Know The Names

Tue Jun 13 2023

InvestingCredit CyclesPrivate CreditDecision-MakingMentorshipTeamworkRegulatory ChangesReal Estate

Description

The episode covers the investing theme of the 2020s, credit cycles and opportunities, credit investing strategies, fast decision-making and alpha generation, private credit funds and market dynamics, building a successful investment business, insights from building Diameter, credit investing strategies continued, effective team management and future outlook, private credit business and market dynamics, building relationships and adapting to market changes, regulatory changes and real estate opportunities. Key insights include the importance of understanding liability structures, the impact of credit cycles on investment opportunities, the need for quick decision-making in the credit market, and the challenges and opportunities in the private credit industry. The episode also highlights the significance of mentorship and teamwork in building a successful investment business.

Insights

Understanding Liability Structures

Credit investors need to have a deep understanding of liability structures to navigate market downturns.

Impact of Credit Cycles

Credit cycles drive investment opportunities as companies experience booms and busts due to economic changes.

Quick Decision-Making in Credit Market

Making quick decisions within seconds or minutes is crucial in the credit market.

Challenges and Opportunities in Private Credit

The private credit industry faces challenges such as liquidity issues and dilution of alpha, but there are opportunities for those who can provide liquidity and focus on specific opportunities.

Importance of Mentorship and Teamwork

Mentorship and teamwork are crucial for success in the investment business.

Building Relationships and Adapting to Market Changes

Having the right LPs, transparency with investors, and adaptability to market changes are key factors in building a successful investment business.

Regulatory Changes and Real Estate Opportunities

Regulatory changes will impact the need for credit risk transfer transactions, and real estate market imbalances present future distressed opportunities.

Chapters

Investing Theme of the 2020s
Credit Cycles and Opportunities
Credit Investing Strategies
Fast Decision-Making and Alpha Generation
Private Credit Funds and Market Dynamics
Building a Successful Investment Business
Insights from Building Diameter
Credit Investing Strategies Continued
Effective Team Management and Future Outlook
Private Credit Business and Market Dynamics
Building Relationships and Adapting to Market Changes
Regulatory Changes and Real Estate Opportunities

Summary

Transcript

Investing Theme of the 2020s

00:00 - 06:26

The theme of the 2010s was private equity, shareholders, return of capital, dividends, and zero rates.
In the 2020s, the theme will be driven by inflation and higher rates, with a focus on returning capital to lenders, pensioners, savers, and creditors who were robbed of it in the past.
This transition will take time but presents opportunities for credit investors.
Pensions may rotate into investment-grade corporate debt to diffuse their liability.
Companies with too much debt may transfer value back to creditors as rates rise.
The skill set differences between equity and credit investors involve thinking about downside risk versus upside potential and considering both asset and liability structures on balance sheets.
The example of Carvana demonstrates how market valuations can change when interest rates shift.

Credit Cycles and Opportunities

06:01 - 12:26

Now it's people realize that rates are not going to be zero forever so their finance business effectively subprime finance business isn't earning as much as it was the tam is what it was.
They're just not that good at selling us cars but i think you go into bubbles and the fed the inflates and deflates them in the one were were on the precipice of deflating right now or just in the process of beginning to deflate driven by tech.
Healthcare, venture, private equity in zero rates, and private credit. It's all zero rates.
Where can I put my money where there's convexity?
When there's no yield, people hunt for other ways to get convexity or optionality.
The concept of a credit cycle drives a lot of where the opportunity is.
Credit cycles are booms and busts in the economy associated with companies that are either cyclical or have a problem due to an economic change.
There are series of micro cycles going on all the time in different sectors.
The liability side edge within the credit universe has largely been competed away.
The first cycle mentioned involved project finance, telecom, power, asbestos bankruptcies, high yield market, tradable bonds, investment grade market, power, telecom and fraud.
The LBL boom and bust involved LBOs and high yield issuance driven by private equity boom and housing bust.
In Europe during 2010-2015 there was intervention by sovereign corporate debt markets buying a lot of debt and support in the market which distorted the corporate bond market for a long time.
In 2015-2017 there was an energy and commodity bust which was sector-driven with a ton of new issuance in energy due to shale boom.

Credit Investing Strategies

11:57 - 18:10

During the credit cycle, distressed funds are drawn to low dollar prices.
Opportunities arise when bonds of first or second quartile companies trade down in credit.
Knowing the names and being familiar with them is crucial for success in credit investing.
Credit investors typically have rules-based approaches and daily liabilities.
Making quick decisions, within seconds or minutes, is necessary in the credit market.
Banks are no longer providing liquidity consistently, so firms like Diameter aim to be providers of liquidity at inflection points.
Full-cycle investing within a sector allows for proactive decision-making.
Being product specialized in trading increases the likelihood of receiving opportunities from banks.
Diameter's process involves making decisions without an investment committee and relies on the expertise of its founders.

Fast Decision-Making and Alpha Generation

17:51 - 23:56

The hedge fund and drawdown fund operated by John and the speaker do not have an investment committee, allowing them to make fast decisions together.
They maintain a list of vetted names with analysts that is updated quarterly.
During COVID, they received a call from the head of loan trading at B of A who wanted to buy $500 million worth of loans within 15 minutes.
They were able to respond quickly because they had shared their list with the banks and had a track record of providing liquidity during dislocations.
They bought software loans in the lever-loan market at a discounted price due to the recession, which turned out to be a good defensive move.
The ability to process information quickly and be prepared allows for fast decision-making and alpha generation.
In terms of alpha sources in credit, early on it was understanding liability structures better than others.
During the GFC, holding trades or having liquid investments that could change positions was important for generating alpha.
Liquidity-adjusted returns are considered when investing in illiquid assets.
Lessons were learned from watching others' mistakes during times like the Sowood collapse in 2007.

Private Credit Funds and Market Dynamics

23:28 - 30:05

Private credit funds now have funding that matches the LP capital and the leverage matches the duration of the assets.
There is still a lot of money in daily liquidity ETF mutual funds, which creates intraday and intermonth volatility in credit.
Having a process that allows for speed of decision making is alpha in credit markets.
Liquidity provision with a real knowledge of underlying credits and better margin of safety can be a successful strategy.
Big institutional pools of capital have relatively fewer credit managers, possibly due to their focus on equities and private equity in recent years.
Credit fund performance from 2013 to 2018 was poor, especially for distress funds investing in coal, newspapers, shipping, and bad energy bonds.
Some funds are getting too big, which dilutes alpha. Size can be a detractor if trading and speed create alpha.
There is now a cost for being illiquid as the Fed's support has become less reliable.
Being too big can limit flexibility in trading strategies and result in becoming an index proxy rather than focusing on specific opportunities.
Management fees and growth of AUM were prioritized over returns by some credit hedge funds, leading to pushback from LPs.
Scalability issues in capital markets and shorting need to be considered when sizing hedge funds for maximum returns.

Building a Successful Investment Business

29:54 - 36:10

The firm's scalability has been enhanced by opening the London office in Europe.
The firm's culture and DNA are strongly influenced by the personalities of the founders.
The alignment between investors' personalities and the firm's values is a key factor in their success.
The guest shares his personal story, starting with his childhood and early interest in sports.
He participated in Bill James fantasy baseball at a young age, which sparked his interest in statistics and data analysis.
Through connections made on a train, he had the opportunity to learn from experienced investors and gain exposure to the finance industry.
These mentors taught him valuable lessons about learning from mistakes, integrity, trading, and banking.
Apprenticeship and mentorship are crucial for success in the investment business.

Insights from Building Diameter

35:45 - 41:45

Alignment is crucial to create a culture where people support each other's success.
Senior team members should help their colleagues succeed, even if they are not performing well themselves.
Liability structure is important for managing through market downturns.
Raising enough capital upfront is essential to be relevant and provide liquidity to banks.
Managing the relationship between different backgrounds and skill sets requires coaching and communication.
Hiring analysts with both depth and breadth of knowledge is important for a startup investment firm.
Process and preparation are necessary to cover sectors, anticipate events, and be ready for opportunities.

Credit Investing Strategies Continued

41:23 - 47:42

Changed hiring process to find candidates with depth and breadth
Implemented three different cases for testing depth, networking, and speed
Strong network is critical in credit investing
Imagination plays a role in credit investing, especially on the structuring side
Considered narrative of a company during distress situations
Invested in different parts of the capital structure based on changes in macro and micro factors
Partnership between the two individuals is symbiotic and essential for success
Met regularly for breakfast meetings to discuss credits and investments

Effective Team Management and Future Outlook

47:26 - 54:32

Every Sunday morning, the podcast hosts meet to go through their hedge fund and drawdown fund portfolios.
This exercise helps ensure they are on the same page in terms of risk.
They have only missed two meetings in six years since starting the business.
The team takes notes during these meetings for transparency and alignment.
On Sundays at 4:30 PM, the research team sends their focus for the week and long-term goals.
The whole team meets on Monday mornings to discuss everyone's workflows and maintain transparency.
Tracy Fenton, a coach recommended by Isaac, helps with management skills and team dynamics.
She assists with process, hiring, culture, and ensuring appropriate support for team members.
Tracy asks insightful questions about human interaction and encourages reflection on past actions.
In the next decade, there needs to be a shift from valuing illiquid assets to exposing vol washing and low dispersion within asset classes.
Fees should be based on manager quality rather than product type.
There is an opportunity in private credit with first lean debt at low loan-to-value ratios.

Private Credit Business and Market Dynamics

54:03 - 1:00:45

Private credit business focuses on senior secured lending
Private credit is both offensive and defensive for the company
Building relationships with sponsors and learning more about management teams helps with investing across the platform
Legacy books may distract from new opportunities in private credit
Transparency and calling balls and strikes make the team intellectually honest
Selling positions before they go down is a differentiator for the portfolio manager
Loss avoidance and anxiety of missing things motivate the speaker
Joy comes from when technical, trading, research, and risk elements come together for an event
Having the right LPs can make a big difference in the business

Building Relationships and Adapting to Market Changes

1:00:16 - 1:06:39

Having the right LPs can make a big difference in a business.
Not taking a seed investment was the right decision, advised by Dan Stern.
Seed investments can be like golden handcuffs and change the economic structure.
Transparency with LPs is important, as well as having two-way relationships.
Access to different pools of capital with different mandates has been rewarding for learning and growth.
Raising enough capital to prosecute your strategy is crucial in the early years of an investing business.
Staying focused on your area of expertise and adaptable to market changes is important for success.
AI is more relevant to the equity market than the credit market, but it can disrupt businesses both positively and negatively.
AI has potential for creating short opportunities in credit markets if it disrupts certain industries.
Banks are being disrupted from a capital perspective by private credit lenders, leading to regulatory focus and derivative hedging trades.

Regulatory Changes and Real Estate Opportunities

1:06:14 - 1:11:22

Banks are being disrupted by private credit lenders and regulators are focusing more on them.
Regulatory changes like Basel III or Basel IV will increase the need for credit risk transfer transactions.
Diameter main fund is always unfinished business, but they have a three to five year plan to improve.
Real estate market imbalances present future distressed opportunities.
Shorting opportunities in real estate are limited due to unshorable securities.
Building a team focused on long-term real estate opportunities in public and private markets.
Occupancy uncertainty makes investing in office space challenging.
John's wife, Kimberly, made personal sacrifices to support his business endeavors.
Dan Allen and Davis supported John when he started building his business.