David Lyon – Hybrid Capital Solutions for Private Assets (EP.471)

David Lyon is Managing Director and Head of Capital Solutions at Neuberger Berman, where he oversees $10 billion of AUM and deploys $2-3 billion each year originating large scale financing solutions to premier sponsor-backed companies. Over three decades, David was the first arbitrage analyst at Och-Ziff in the mid 1990s, an associate at one of the then largest private equity firms in the late 1990s, and a fundamental, distressed debt investor at quant hedge fund DE Shaw through the GFC. His experiences offer a deep understanding of both sides of the balance sheet, which he brought together in hybrid capital solutions over the last decade. Our conversation traces his journey, lessons learned along the way, and perspectives on today's private markets. We then discuss the need for flexible capital solutions to address private equity liquidity challenges, competitive differentiation in the space, and the process for making it happen across sourcing, creating solutions, and managing risk. Along the way, David shares his refreshingly honest views on investor expectations, leveraged capital structures, good and bad investments, and incentives that help navigate an increasingly crowded marketplace. Learn More Follow Ted on Twitter at @tseides https://twitter.com/tseides?lang=en or LinkedIn https://www.linkedin.com/in/tedseides/ Subscribe to the mailing list https://capitalallocators.com/ Access Transcript with Premium Membership https://capitalallocators.com/signup Editing and post-production work for this episode was provided by The Podcast Consultant (⁠https://thepodcastconsultant.com⁠ https://thepodcastconsultant.com/)

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Speaker 00

  I always laugh and I tell my investors, people that show you the same decks that say "Wall of Maturities," it's never happened in the history of finance. People say, "Oh, my God, I forgot I have a maturity." Good companies finance those ahead of time. It's only the bad ones that can't refinance themselves and people figure that out. They talk about fraud in China. They talk about debt to GDP. I call it the boogeyman slides. They're saying, "World's going to end. I have capital."

• 0:28Ted Seides?

  I'm Ted Seides and this is Capital Allocators. My guest on today's show is David Lyon, Managing Director and Head of Capital Solutions at Neuberger Berman, where he oversees $10 billion of assets and deploys $2 to $3 billion each year, originating large-scale financing solutions to premier sponsor-backed companies. Over three decades, David was the first arbitrage analyst at Oxfam in the mid-1990s, an associate at one of the then-largest private equity firms in the late 1990s, and a fundamental distressed debt investor at Quant Hedge Fund DE Shaw through the global financial crisis. His experiences offer a deep understanding of both sides of the

• 1:13Ted Seides?

  balance sheet, which he brought together in hybrid capital solutions over the last decade. Our conversation traces his journey, lessons learned along the way, and perspectives on today's private markets. We then discuss the need for flexible capital solutions to address private equity liquidity challenges, competitive differentiation in the space, and the process for making it happen across sourcing, creating solutions, and managing risk. Along the way, David shares his refreshingly honest views on investor expectations, leveraged capital structures, good and bad investments, and incentives that help navigate an increasingly crowded marketplace.

• 1:56Ted Seides?

  Before we get going, it's that time of year when we turn to traditions like the tradition of Thanksgiving, gathering family and friends to share what we're thankful for. One of which is the ability to eat enough turkey and tryptophan to fall into one of the best slumbers all year, that nap on the couch while watching football. While I'll spend the turkey days with my family, I'm particularly grateful this year for the incredible team of professionals that brings together what you hear and experience with Capital Allocators. That's Hank, our CEO, Morgan, our Head of Ops, Tamar, our Head of Business Development, and Liz, our Head of Content. I'd put our

• 2:35Ted Seides?

  starting five up against any NBA All-Star team off the court. Our values of quality, entrepreneurial spirit, intellectual curiosity, respect, generosity, and fun win championships. Although I can't say the same on the court for my getting dunked on, because at 6'1", I'm the least vertically challenged of our starting five. Outside the office, I'm grateful for you, for listening, engaging with our guests, and sharing kind words all year long. This podcast is the gift that keeps on giving. So before you start the mad year-end dash to calculate performance, conduct 360 reviews, and shop, take this time to be grateful for

• 3:18Ted Seides?

  the many gifts in your life. As my friend Dasha Burns recently shared on the occasion of my 55th birthday, "May the best of your yesterdays be the worst of your tomorrows." While you're feeling all warm and fuzzy, don't forget to spread the word about Capital Allocators to those closest to you to give them the gift that keeps on giving. Capital Allocators is brought to you by AlphaSense. Every allocator sits at their desk for hours preparing the work around investment decisions, getting up to speed on a new theme, prepping for the next investment committee meeting, and tracking what changes across an entire portfolio. AlphaSense just launched something built to help. It's called

• 3:59Ted Seides?

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• 4:41Ted Seides?

  The best way to judge its quality is to give it a whirl. Pick the research task on your desk before your next committee meeting and hand it to SuperAnalyst. Start a free trial at alphasense.com/capital and see what it has ready for you. Capital Allocators is also brought to you by RidgeLine, the investment management platform built for firms who are rethinking how work gets done. You're at your desk, looking at a line graph of your firm's growth. The line is moving sideways, linear growth, and you know exactly why. You're constrained by your operational bandwidth that's been the same for so long, it just feels like the cost of doing business.

• 5:25Ted Seides?

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• 6:07Ted Seides?

  If you file Form ADV, your firm is already there. Then talk to RidgeLine about how you can do more with the team you already have. Capital Allocators is also brought to you by Juniper Square, the operations partner trusted by the leading private market GPs. One theme that keeps coming up on the show is GPs that build the strongest and most durable relationships with LPs are the ones that have both strong returns and strong operations. AI raises the stakes on operations and having Juniper Square as your operations partner helps ensure your data is organized, accurate, and accessible so you can unlock operational

• 6:48Ted Seides?

  alpha. That's why thousands of GPs trust Juniper Square. Learn more at junipersquare.com/capitalallocators. Please enjoy my conversation with David Lyon.

• 7:04Ted Seides?

  David, so fun to do this with you.

• 7:05Speaker 00

  Ted, great to see you. We've known each other for, what, 28 years? So go back a long way.

• 7:11Ted Seides?

  We're not going to go there.

• 7:14Ted Seides?

  Why don't you take me back to what it was like growing up in a family where you and your brothers all ended up in investing in finance?

• 7:22Speaker 00

  We were typical middle-class family in New Jersey. My dad was not in the business at all. He was an engineer. My oldest brother got into the business by accident. My mother knew someone that she played golf with. Her husband was a partner at Goldman and she asked, "What is your son doing?" And he said, "I'm going to go work for a big wheel company and do chemical engineering." She casually said, "Well, have you thought about investment banking?" No one in my family had any idea what that was at the time. My brother was a smart guy and ended up interviewing and getting a job. That's how my family accidentally discovered investment banking. I had another brother who's still in the business. He went through the process and I was really lucky because when I was in college, I knew what

• 8:05Speaker 00

  an analyst program was. I knew the questions they asked you in interviews and all those sorts of things. Now, I wasn't a finance major. I was a liberal arts major. I didn't grow up with a dad who was obsessed with stock picking. I didn't have any of those things. I was very fortunate that I got exposed to a bunch of those analyst programs and the interviews and was able to figure out how to bumble and stumble my way through them. And I was lucky enough to get offers at a couple of banks and I went to Goldman Sachs. The big advantage for me joining that analyst program was since I never really learned a lot of that stuff formally, I had to figure it out for myself. I'm a common sense oriented person. I had to understand the principles from a common sense perspective. And finance is relatively simple.

• 8:47Speaker 00

  I'm not talking about upper level mathematics here, but basic concepts, being able to teach yourself, those things was very powerful for me. I was very lucky to have exposure to it, very lucky to have older siblings that understood this space. And I was ready to work. I was a dumb kid. I didn't care about working 100 hours a week. I thought it was the most glamorous sexy thing in the world to send faxes to partners Hampton's houses and number the pages to make sure that he can get jammed up in the fax machine. I was also very lucky when I started doing this in 1994, M and A was booming. We didn't have a huge team in my analyst class and I worked on live things. I didn't do pitches and God knows what damage I caused when I was 22 years old.

• 9:31Speaker 00

  Got exposure to management teams, to sell side processes, to raid defenses, all of those things with a courtside seat. That was an amazing experience for me. I got to work on some pretty large companies and get it from the inside without pitching and always losing and just doing decks. I was thrown into the boardroom and I don't think it was adding a lot of value, but I got to watch it firsthand.

• 9:52Ted Seides?

  So we can go from early banking to early hedge funds. What is that experience like?

• 9:58Speaker 00

  I was a good analyst, well rated or whatever that is in the analyst program. But you realize a lot of that is just doing a lot of perfunctory things. When you step back after 30 years, you were making sure a deck got done. You were making sure the merger model was right. Back in the day, we didn't have the internet. We had to go down to the stupid IBIS machine and get the estimates off the machine and we had to get paper stacks of SEC documents. A lot of that was navigating a process, making sure the deck was on, you're going down to word pro. 30 years ago, we didn't have Excel. You had Lotus 123. You had to print it out and get word processing to transpose it. From there, make sure there were no mistakes in it, put it in the book, make sure the book's produced correctly. A lot of your job was that. Being good at that doesn't mean you're a great investor. It means that you're good at.

• 10:41Speaker 00

  People yelling at you, it means you're good at handling abuse and being incredibly inefficient with your time, but you thought you were efficient. Then step into day one, I joined a hedge fund and I was one of four or five people there. And I remember just the absolute pain and agony I felt of, I was the youngest person there probably by 15 years. In terms of real chops about what to do, I had no idea. My first week, someone asked me about a stock. Should we buy it or sell it or what should we do? I think we owned it and they asked, should we sell it? I remember asking, what's our basis? What did we pay for it? The amount of anger and fury was like, what are you, an accountant? Who cares what we paid for it? It's only what it's worth right now. That doesn't matter. I was like, oh my God, being thrown in the fire.

• 11:25Speaker 00

  But that was terrific because I got to firsthand deal with an investor who was on the front lines doing this. He was not afraid to tell me I was an idiot. That was a massive learning experience for me to understand how to think about up down, how to think about the source of our edge. Why do we know something that no one else knows? I originally was in a risk arb fund, a special sits fund. We weren't doing stock picking. We were trying to take advantage of structural inefficiencies. Back in the day, risk arb was an amazing business. It wasn't 5%, it was 20%. I was thinking back about, God, I wish I knew what I know now then. Because having a market that could produce those rates of return by being one of the few participants is really an anomaly. It doesn't happen, especially today, how competitive finance is.

• 12:09Speaker 00

  You could make real returns by being one of the few players in a structurally inefficient market. That's very different now in the hedge fund space. So that was baptism by fire. I was there for a couple of years. I don't think I felt incredibly fulfilled doing merger arb. It wasn't like, hey, David, these two utilities are merging. Go to this conference and talk to the guy from the PUC of Iowa to make sure that the deal's going to go through. That didn't pump my blood. I started thinking about what kind of investing do I want to do? I wanted to be on the buy side, but I thought in the back of my mind, doing something more private equity oriented, only because I liked the interaction with management teams. I liked thinking about how does the company work? If I look back in the day, even with people that were mentors to me,

• 12:52Speaker 00

  my favorite conversations was how do they make a product? How do they sell it? How does the business work? Explain it to me as if I'm an eight-year-old. Understanding a business to that level was most exciting to me. I thought, gee, if I did it in a more concentrated way or in a liquid way where it wasn't about trading, it was about getting in the guts and interacting with management. I went off to business school. I ultimately went into the private equity industry after that.

• 13:15Ted Seides?

  What'd you find when you got into private equity?

• 13:18Speaker 00

  I was in private equity in the late 90s through 2007. At the time, we were the top four or five largest funds in the world. It no longer exists sadly. A couple of things I learned. Raising a private equity fund, there's a lot of marketing behind it. There's a lot of IRR math. There are a lot of stories. People didn't have as deep investment chops back then because at a time you could buy an asset for eight times EBITDA. You could lever it six. The LBO math did most of the work for you in terms of return. You weren't having deep level thoughts about the industry. You weren't doing advanced M and A or trying to buy an asset and heave off a bad part of it or do something creative. You were using leverage.

• 14:03Speaker 00

  The barrier to entry was could you figure out Excel? Could you do that modeling? Could you convince a bank to give you the financing? It was a different business. I regret that the firm I was at didn't capitalize on it because it was a lot easier in the day. I also found basic things that when you have a team of people, because most of these private equity firms have different partners that do different industries, they have to get along and there has to be management. What I learned is having a bunch of fiefdoms and people that have different incentives leads to bad outcomes. Aside from bad investments, as I learned about day one, organization matters. Having someone driving a culture, having someone drive accountability is difficult in a partnership. That's something when I look back is what I learned about that space is how are you going to organize?

• 14:48Speaker 00

  How are you going to invest? Do you have specific themes? Are there industries you care about? Being a generalist, looking at all. Auctions and trying to get as much leverage as possible and do an LBO model, I don't think was a winning recipe for long-term success. A lot of this benefit of hindsight, but early on I got to witness some things that went sideways or backwards pretty quickly, and it was a big jolt to my fragile ego. I got this really exciting job. I was at a big buyout firm. There weren't a lot of people. Then you realize all the things assume away, they're hard. When things go the wrong way, it's tough. I spent many, many years early in my career dealing with things that, some of them went bankrupt, some of them were disasters. That also taught me a lot about why did we invest in this?

• 15:33Speaker 00

  What was our thesis? What were we thinking about? The final thing that I learned is when your thesis in private equity is a person, so-and-so is amazing, that's very dangerous. It's great to back a person. You have to realize that your thesis is I'm backing a person. And God forbid something goes wrong and it doesn't deliver. What do you do? Replace management? Okay, but my entire thesis was Bob. And now that I got to remove Bob because he's not doing well, did I really have conviction about the industry? Did I really like the company's position? I saw a lot of that firsthand. Those are some of the lessons I had in private equity. Dysfunction, people's trust. I'm not saying you have to be best friends and go on picnics every weekend together. What I'm saying is have professional respect, common incentives, not gun for my deal versus your deal and things like that.

• 16:17Speaker 00

  Those things are insidious and they infect a culture and they go from the top down. You've got to be really cognizant of putting the right motivations in place.

• 16:24Ted Seides?

  So after seeing that, that looked like it was going to be great. Top of the world doesn't go that well. Where do you go from there?

• 16:30Speaker 00

  I went to a large hedge fund. This was the oh seven cycle when we were long on the tooth and people thought that the world might end. I pivoted to doing more distressed stuff. Loan to own, get into parts of the cap structure, we're going to become the fulcrum. The hedge fund was a quantitative hedge fund, had what we used to call our qualitative business. And I thought it would be a fantastic place. It looked like we were long on the cycle. Using our skills, especially my skills with things that had been broken before, and having learned how to think about those things and what's a good business, bad business. The aphorism, good company, bad balance sheet, by the way, never exists anymore. But being exposed to that, I pivoted to a large hedge fund that had a huge capital base to go do that. One of the things about this hedge fund that I worked at is it was incredibly quantitative.

• 17:12Speaker 00

  Tremendous smart people. I was one of the least exposed to what they did day to day because they were a blood shop. The one rigor and things I learned, and I think back to this day, is one, always calculating your up and your down precisely. Hey, what am I playing for? What is my real downside? And I remember they used to tell me, I don't want you to be conservative. I want you to be accurate. What I learned from them is, listen, we can take advantage of risk aversion. Often in the market, we get paid because people are risk averse. And if we have a big enough diversified pool of capital, we can take advantage of that. We can buy those risks and assemble them in a pool. So I don't want your risk averse estimates. I want your real ones. And then we can decide whether we want to take that risk and whether actually mathematically it makes sense to do that. And that was a bit of an eye opener because if you come from private equity, it's like,

• 17:57Speaker 00

  oh, these are conservative assumptions and your downside case was 10%. I used to laugh, your downside case is negative 100. If you're a six-time lever company, it goes wrong, you're going to lose all your money. There was a lot of that, gaming the system, running five-year models, and going to a place that was just rigorously quantitative. That was a massive eye opener. They weren't big into the more qualitative parts of the business, relationships, building benches of management teams, things like that. It was a different business for them. That was a big eye opener. And of course, I was in that seat during the GFC. That was an unbelievable time to be there and to do that and have that capital base and see the advent of CDS and what happened to that, all those different things at one time. That was a pretty unique experience for me.

• 18:39Ted Seides?

  As you reflect back your path, arbitrage hedge funds, stress, private equity, credit, I'd love to get your perspective today on each of these now popular alternative asset classes.

• 18:54Speaker 00

  Private credit, if you look at the different pockets of capital in there, the biggest one by far is direct lending. That's what everyone's talking about. And it came out of the GFC when all of the regional banks went away. This was the story they'll tell you. Hey, the syndicated loan market can't support these smaller loans. The banks are in the moving business, not the storage business. They get paid a couple of points to syndicate the CLOs. And as such, we need a home for these smaller things. Make a real spread in doing that. That was the genesis of direct lending. It was a beta strategy from the start. I'm getting paid a spread. You can think that maybe you're getting paid too much. But the whole point was I'm going to invest in a smaller business. I'm going to provide flexible first lien capital and help a lot of sponsor back stuff get done.

• 19:35Speaker 00

  The industry exploded over time because rates were zero and people desperately needed yield. As rates stayed zero for longer and longer and you look what traditional fixed income assets were returning. It became a huge spread. People figured out, well, gee, in direct lending, I can introduce leverage. I can create what I call a baby CLO. CLOs are 10x levered vehicles whose sole purpose is to buy loans. Because coupons are S325, you have to lever it 10x to produce 12% to 15% in equity. In a direct lending fund, leverage is a lot lower because you're getting a significant pickup in spread. You're getting an extra 150, 250 bips. The asset class exploded because institutions needed yield. Today, direct lending competes with the syndicated loan market.

• 20:21Speaker 00

  Big players have hundreds of billions of dollars. They will hold $2 billion in a name. So it's no longer a cottage industry supporting the underbanked. It is a direct competitor to the syndicated loan market. Most of the activity is in private equity owned companies because they're the most prolific users. They're the most active and it's hard to get real reliable statistics on how much is private equity and how much is non. But vast majority is sponsor backed, which kind of gets us the other parts of credit. You have big explosion asset backed, which is Basel IV, Basel V. Banks will be out of this business. I'm going to finance rail cars. I'm going to finance planes. I'm going to finance all these different things. You've had fintech related things, consumer loans. It's all being aided by technology.

• 21:04Speaker 00

  You've also had guys do what I do, which is cap solutions. I used to always laugh because distressed always got thrown into private credit. And I'm like, if you're buying things that trade, it's not private. That was always amusing to me. More and more distressed guys have pivoted to brand themselves capital solutions. Cap solutions is just hybrid capital. That's all it is. You're don't fit in a box traditionally. You're neither just first lien debt or equity.

• 21:27Ted Seides?

  Within private credit, with all the explosion that's happened in the activity, the volume of assets to put to work, what are you seeing in the behavior of the participants?

• 21:37Speaker 00

  It's a finance asset class. What you're seeing is if new buyouts are the lifeblood of that business and new buyout activity has been muted for the last several years, you're seeing a lot of competition in that space and spreads have come down. You have an interesting environment where the height of direct lending was in 2023. Because of the failure of the syndicated loan market, there were a lot of hung deals in 22 and banks lost a lot of money on paper. You had a major participant out and a lot of these direct lenders were financing deals that were getting done at spreads of 700. What that means at the time, S, the base rate was 5.5. Adding 7 to 5.5 is 12.5% for senior secured paper. If you look at prices that were being paid for the assets, they were

• 22:19Speaker 00

  paying 18x, 17x. So you were a third into the capital structure, being paid 13% unlevered. That was Nirvana. Everyone went all over the world and said, hey, forget equity. I can give you 13%. I can lever it in a diversified pool and make you 15. That caused a lot of capital to flood into the ecosystem. Now, what you're seeing is those businesses are attached to a lot of very large alternative asset managers, many of whom trade on FRE. A good way to create FRE is to take several billion dollars of loans and charge 1% on them. That's what you're seeing in the ecosystem. So it's incentives. I'm not saying that the world's going to end. What I'm saying is you're seeing a lot of competition for larger deals to get scale. Participants want to invest big dollars in larger deals and deals that

• 23:03Speaker 00

  are pursued to be high quality where lower probability of impairment, spreads are very tight. And that's what's going on in that ecosystem. You're going to have to calibrate return expectations accordingly.

• 23:13Ted Seides?

  How's that impacted what you're seeing in private equity?

• 23:16Speaker 00

  What I would say in private equity is you had a couple of things happen. Rates were low for a long time. If you're paying 16x EBITDA for something and your capital structure is only six, the incremental pickup in basically spread and rate, don't crater your LBO model because it's a small part of your structure. What it does do is hampers your flexibility, your ability to do Real aggressive add-on M and A. If your coverage ratios are really tight, you have to have confidence about what you're buying. You can't just say, I'll buy a bunch of stuff and see what happens. You're going to have real issues with solvency if you get these wrong. If you do a bunch of M and A and it doesn't produce the earnings you think again, and you keep levering yourself up on a pro forma number, you got to be careful, especially with rates going from zero.

• 23:58Speaker 00

  You used to be able to borrow unitranche back in 21 at 6 and 1/4%. Now those numbers are around 9 and change today. They were 13. You can get a sense of the impact of that. That impacted buy and build. The other thing in private equity is funds got raised, bigger and bigger funds. What's happened is that a lot of these assets are huge. A lot of these companies that are good businesses and business services and things with high margins that are low capital intensity, a lot of them are valued at 15, 16, 17 times EBITDA. And if it's 150 or 200 million of EBITDA, the exit alternatives are limited for that. It's very different when you were writing an equity check up 50. The exits available to you were multifold. You could get out through another sponsor. You could do more M and A.

• 24:42Speaker 00

  There was always someone big enough that says, oh, this platform's interesting. I want to grow it. Today, if you have a margin optimized company that's worth 16 times and it has a billion dollars of equity in it, and you want to just do some basic math and you want to earn a 15% return over five years, well, that's a double. You got to take a billion and turn it into 2 billion. A lot of these companies don't really delever because as you know, EBITDA is not a GAAP principle. If you took operating income and added DNA to it, it wouldn't be the number that's presented to you. There isn't a ton of free cash flow in these models. You really have to grow the top line. You have to think about who's going to pay the same price for this asset in five years? That's what's confounding the industry, which is it's very difficult to pay 16 times for something and then assume multiple contraction in your buyout model,

• 25:27Speaker 00

  three, four, or five years into it. The implied growth is huge for you to make a 20-plus percent return. That's impacting the industry. What you're seeing in private equity was a golden age. Rates were low. Capital formation was awesome. People doing smart things. The advent of buyout step never happened. Meaning in the past, you couldn't do a software deal. Lenders wouldn't give you the Capital and they would say, oh, your assets walk in and out the door every single day. And now they're the most aggressively financed companies on the street because people realize, wow, there's a lot of recurring revenue and people don't throw out their ERP systems. There were innovations as the industry got more competitive. It's more difficult to innovate because other people see what you do and can copy it very quickly. Private equity is not dead. It's mature and it's cyclical.

• 26:11Speaker 00

  People are going to have real impact of the activities in 2019 and 20 and 21. We're seeing that it's a real factor today.

• 26:19Ted Seides?

  How did those two things work together where there seems to be an endless abundance of credit capital available for a sponsor? But the sponsors have this pricing issue in terms of generating the returns they need to for their LPs.

• 26:33Speaker 00

  Credit's still hot. The uni markets are back to where they were. You can get six and a half, seven times leverage on the right assets if you need to. It's more expensive because of base rates, but spreads are very tight. Credit's not the problem. The problem is bid ask. If you looked at 2022, the S and P was down 20%. The NASDAQ was down 30%. Let's say private equity lives somewhere between those two worlds. Private equity was flat for the year. Compounding is pretty powerful. People now look at public comps. That's where you're having issues with these marks. You've never had any dip in the number. A lot of private equity firms, what you're seeing is the biggest institutions are capital formation machines. They're excellent. They're well run, they're well managed. The vast majority of capital being raised in private equity, I think the number is two thirds is the top 10 firms.

• 27:19Speaker 00

  What you're seeing is a shakeout in middle market. Middle market, by the way, is not tiny. It's 2 billion to 15 billion, somewhere in there. You're seeing real issues there. There are thousands of those players. You're seeing those folks with difficulty in returning capital. At the same time, some of them don't want to say, hey, this is a great asset. I think comps say it's 17. I'm not going to mark it down because I still got to raise my next fund. That circle is pretty powerful. We're seeing a reluctance for people to say, hey, I think this is a good company. This is what comps suggest. It's fair value. But when you go put it out for auction, it's hard to get that number, especially if it requires a billion and a half dollars of equity. That's right now what you're seeing in the industry.

• 27:58Ted Seides?

  I just love your quick take on hedge funds where you started your career.

• 28:01Speaker 00

  What I did and what multi-strat do is a very different animal. My experience in the business was a relatively small pocket of capital doing event-driven stuff. We weren't stock pickers. It was a pretty narrow universe of guys that did this stuff. We knew which lanes we were swimming in. There's been a massive evolution in the products. You have quant funds and you had multi-strats that became huge. Not all of them have fared well. Some have had some issues, but I'm always impressed with the people that are running these 10, 15, 20 billion dollar funds that managed to put up decent numbers and really stay ahead of flows and focus on three or four industries. It's very, very difficult to do that. The industry had a tremendous backlash for a while.

• 28:46Speaker 00

  It was dead. It's come back. If you talk to people in that space that manage real dollars, it's a challenge. You know it very well. You used to allocate it to it. There are very few people that are gifted in doing that when you're fundamentally stock pickers in size. It's just a handful of folks I think have real talent in doing that.

• 29:01Ted Seides?

  So you go back to the private markets. You have this disconnect in bottleneck between credit and the equity. As you mentioned, you're now in the capital solutions business. Can you talk about what that is and where it came from?

• 29:16Speaker 00

  In essence, it's any capital that's non-traditional. The first thing I alluded to was distressed. There is no distressed market. What's happening is 30 years ago, there was a bigger premium to be in distress. If something were complicated or hairy or on the verge of insolvency, a lot of people said, ah, I don't want to deal with that. That's gross. So you had a bigger discount at play in that space. On top of that, you actually had higher carry. Rates were structurally higher. You could sit on a loan and buy it at 75 and make a rate of return just by taking in the coop. When rates got super low and the notional yields were 4%, it was hard to make any money buying something at 77. More people came in the industry. What happened is distressed only became interesting when there was dislocation.

• 30:00Speaker 00

  Right now, if you look at dislocation, during COVID syndicated loans traded below 80 cents for eight days. During the GFC, 294. Big difference. To take advantage are incredibly narrow. People realized very quickly, oh, this is a $500 million EBITDA software company. And it went from par to 78 because people freaked out that we were all going to be living in caves. That's silly. And that inefficiency went away. That's not a strategy. I always laugh and I tell my investors, people that show you the same decks that say wall of maturities. It's never happened in the history of finance. People say, oh, my God, I forgot I have a maturity. Good companies finance those ahead of time. It's only the bad ones that can't refinance themselves and people figure that out. They talk about fraud in China.

• 30:45Speaker 00

  They talk about debt to GDP. I call it the boogeyman slides. They're saying world's going to end. I have capital. But before that happens, and no one knows when it's going to happen, all the things that people look at are already baked into the cake. It's the exogenous factor that no one knows it causes the thing to topple over. I always tell people, so you're going to be at the bottom with all dry powder? That's your strategy? That's silly. People are realizing that that's not the case. Lot of stress guys said, well, all right, worlds are becoming fundamentally more private. I want to pitch that I'm going to be able to inject capital into these companies. And a lot of their pitches, see how big direct lending became? There's obviously a car crash there coming. I'm going to be the guy to benefit from it. People love pitching themes. This theme is what's been proliferating around the street. I hate that investment theme. This is my bias.

• 31:30Speaker 00

  I don't believe it's possible for any single person to assemble a reasonably diversified portfolio of 20 broken things. You can have an edge in one or two things where you think there's possibly a turnaround. You might know an operating executive or understand the model. Can you do that at scale? I don't think so. My opinion, that's where you're seeing most people in cap solutions. There's some angle of distress. It's balance sheet repair. If you're injecting junior capital into a company, most cap solutions are junior capital. They're some form of either a note at holdco, can be a preferred stock, can be a convertible preferred stock. But it's some form of flexible junior capital. And the premise is you're somewhere between senior secured and equity. You're a hybrid.

• 32:10Speaker 00

  If the company's got existential problems and it could potentially default, you can call yourself whatever and you're not going to do well. If you're at holdco, the liquidation preference and the company can't pay its interest. That's not good. I have a fundamental bias against people pitching downside protection in junior capital and selecting things that are tricky, damaged, sexually challenged. So that's one bucket. Eight years ago, when I raised our first fund, we were an ops fund. We were, I hate to say it, me too. And half of what we did was buying loans and buying bonds in the secondary market. And eight, nine years ago, I had an epiphany saying, God, this business is difficult. I don't have an edge in being the 75th guy looking at the same loan at 75 cents.

• 32:54Speaker 00

  What edge do I have? It became apparent to me that, oh, we have lots of relationships with private equity guys. We're thoughtful about structure and how to price risk. This market's inefficient, meaning this hybrid capital market, there are a lot of people who do it. We began to pivot into that business in 17 and 18. Then I realized, wow, what's really interesting is in smaller deals, when transactions are 20 or 30 or 40, lots of people can do those in terms of size. Hedge funds, they'll have pockets of capital. They can write a 20, they can write a 30. Insurance companies, they don't like to direct things. Any guy that raised $300 million in a cap solutions fund can do a 20 or 30 million dollar transaction. As a result, lots of competition in that space. The other thing I realized that there is no barrier to distressed. It's only if you're crazy enough to do it.

• 33:38Speaker 00

  Company needs money, they're going to have a restructuring advisor, they're going to call whoever's going to give them money. There is no barrier to entry in that space. If you have the capital and you're willing to engage in it, you can do it. I was trying to do something that was less competitive, where there was a real mode around it. I realized one of those things was scale. As private equity got bigger, thematically I saw, wow, they're going to be need for larger checks. Those bigger companies that are in stable industries, they're better managed. They're more professional. When you're dealing with a $4 million EBITDA company, you're going to be rolling up your sleeves. Maybe it isn't the most sophisticated, maybe it isn't the deepest bench, and this is going to sound stupid, but $500,000 matters when you have 4 million of EBITDA. The businesses that we're looking at 200, 300 million, management teams own a significant part of them.

• 34:20Speaker 00

  They're professionally run, they are good systems, they are scaled. I felt much better about the underlying quality assets. If I was going to be junior capital, I wanted to sleep at night. And I wanted to write checks with conviction and say, this is a great company. Our whole premise was, can we get in really good companies? Can we be in a part in the structure where I think there's massive room for error? Maybe the company isn't worth 17x pro forma adjusted EBITDA. Maybe the guy who's going to take that risk is the guy who owns the equity. This is going to sound basic, but if a company is marked at 16 or 17x and it has 6x leverage, that means there are 10 turns of equity. If multiples come down by 2 turns, you just lost 20% of your money. I didn't want to take that risk.

• 35:03Speaker 00

  Our premise was, can we get into really good things that are good industries, good companies, that are well-run and figure out a way to shield our investors from what's happened to private equity? That's really how we pivot it, and that's our model. We have a few competitors who do that at scale. What's unique about what we do for a while was it was difficult to raise these funds because allocators looked at them and said, "You're neither fish nor fowl." I got my credit guy, and that's a yield. I got equity, and equity's equity. I remember talking to insurance companies in 2021, and the first question was capital charge. I care about how much money I got to put down. Well, you look at our fund, it's probably going to be equity treatment. They're like, "Well, no, my equity book returns 30%." And I'm like, "It does? I should do what you do." And of course, now today, they're like, "Can you do 10? That would be amazing." There are people that have different variations of this theme.

• 35:48Speaker 00

  The big push is there's 3 trillion, 4 trillion, whatever number you believe, in unrealized private equity NAV out there. It's a big number. Private equity will become interesting again. The regular buyout business is going to take a couple of years for that to get fleshed out. We're addressing the NAV today. Because there's so much of it, at least there's opportunity to sift through it and figure out what's interesting. And then the other thing I like about private equity is there's a whole bunch of weird structural inefficiencies about raising funds, about returning capital, about doing things that are not just pure intellectual, sitting in a room, doing the thing I would do if I had unlimited dollars and building a theoretical portfolio. You have LPs. You have different motivations at stake. You have funds that are in the carry, not in the carry. These motivations influence decisions about when to return capital.

• 36:33Speaker 00

  That's a nice thing to know. In finance, there are some people historically who have been incredibly talented about spotting trends, about seeing around the corner. What's nice is to have a handicap. If you have sometimes structural inefficiencies, that goes a long way. Way to building a scaled business. The other thing that we bring to the table is a lot of people entering this business are competing with other private equity firms. We are neutral in this space. As a result, we get looks at a lot of things. You can be the smartest person in the world and I'm not, but you can be. If you see three bad deals a year, you know what you're going to do? Three bad deals. It's nice to see 300. Real like, oh, here's the range of stuff to do. This seems relatively more attractive. That's the key to doing this. It sounds simple.

• 37:18Speaker 00

  When you're buying public stocks, you know your universe. It's there. You can be an introvert sitting in a room and being very good at. Our business involves something different. You got a source. There's still inefficiency about sourcing. Do you know a management team? Do you know XYZ banker who's your friend and you had a drink with four nights ago at some event? Those things all come into play. As long as you work that system and get a reputation for being someone good to deal with, someone who'll close on deals, someone who doesn't retrade people. It's virtuous. You get to see more and more stuff. That's how I thought about if you're going to build a business of scale, you've got to have some advantages and you got to have reasons why you get paid. I would like to tell you that I can predict the future. Sadly, I cannot. That's been our business model for the last seven, eight years.

• 37:59Ted Seides?

  I want to dive through how you do it. If you take a step back, you mentioned the importance of scale in this business and the strategy you're pursuing. Love to hear about the Neuberger platform and how that fits into it.

• 38:12Speaker 00

  Neuberger Berman is a $500 billion plus or minus asset manager. We have traditional equities, traditional fixed income, and we have alternatives business. The business is roughly 150 billion today, give or take. The roots of the business were, there was a fund of funds a long time ago. It branched into co-investments. We built a secondary's business. We have a direct lending franchise. We have a cap solutions business. We have a specialty finance business. The thesis was we're not going to do controlled buyout. We can be a provider of capital in this ecosystem. The platform invests five to six billion dollars a year in private equity. People know us. People trust us. We're very relevant. We're both in the US and Europe and in Asia. It starts with relationships who you know. Private equity guys are smart. They're good at capital markets.

• 38:56Speaker 00

  They don't become successful. By giving people free money. I'm pretty sure that doesn't work. A lot of that helps you get in the door and give you access and then it's what you do with it. Our platform's powerful because scale, as I mentioned, our funds don't have to be $14 billion individually to do a deal. When you raise a 14 or 15 or 16 billion dollar fund, it's challenging because you got to populate it and your money isn't there forever. Our funds typically are more reasonable in size, but we have so many different pockets of capital on our platform that we can scale. We can do a seven, eight, 900 million dollar investment. And there are different people want different exposures without having to raise a 20 billion dollar vehicle to do that. There are different sides of the house. We actually all get along.

• 39:38Speaker 00

  And many alt firms are siloed. There's a lot of people that have competition that have issues with each other. These relationships go back a very long time. Tony Turtone, who built our platform, did a wonderful job with people and with motivations and incentives. And so there is collaboration. That's very, very powerful. The ability to work together to figure things out and say, hey, this could go in this pocket and this pocket. And we'll figure out a way to slice this up. Our platform does everything from invest in private equity funds on the fund to fund side, to do syndicated co-investment, to pricing minority equity, to doing preps and hybrids and converts, direct lending, all of those things in scale across the private equity ecosystem. So that's fairly unique.

• 40:17Ted Seides?

  When you have that breadth of activities and relationships, what does that sourcing funnel look like for your business?

• 40:25Speaker 00

  It depends on what you're doing. If you're sourcing a direct lending transaction, you want to be in front of the capital markets person at a private equity firm. And that person's sole focus is to go out and try to secure an attractive cost of capital because that market has become more mainstream. Those capital markets people know the people to call and know who can speak for what size. I don't want to say it's perfunctory, but it's a relatively straightforward process. When you're doing these hybrid instruments, we don't want to talk to the capital markets guy. Because generally we're expensive. If you're talking to someone whose sole purpose in life is to get the cost of capital down, that's not a good place to go into. What we want to do is traffic in a couple industries. The reason why that is, is there's nothing wrong with being an automotive supplier. There's nothing wrong with being a commodity chemical producer or drilling for oil. All those things are terrific.

• 41:09Speaker 00

  Buy equity. If you're going to go do that and take some risks like that, don't do hybrid capital in things that have more volatility or extremely capital intensive. And so we'll mine parts of business services, parts of software that we can understand, parts of healthcare that are underwritable. Then we'll get deep in those industries. We'll do the conferences and we'll get to know the individual deal partners at these PE shops and start talking to them about what's going on, what deals have you worked on? What are you thinking about? Then you get deeper and what happens is, oh, I need to go get something done. I need capital relatively quickly. Who do I trust? That's powerful versus cap markets guy who's trying to get you down in cost of capital.

• 41:50Speaker 00

  We use that to our advantage. Our counterparties are smart, sophisticated, the best in the world at this stuff. If you give them enough time, you will lose. Every time you will lose. They will take your face and drag you through the mud and make you eat the mud. However, if you can say, I can get this done. 400 million, 500 million, three weeks. I know this industry. I've looked at before. And that's the combo you want. Do you know your areas well enough? You have to do all of your own diligence. You're not just going to rely on someone saying, well, I told you. You're going to hire your market study if you need that stuff, parts of it. You're going to hire your own accountant if you need that. But do it quickly enough because you understand the basics of that industry and what to look for. And then speak with conviction and size. That's how you earn excess return in our space. Waiting for someone to syndicate risk to you is not how you're going to do it in these capital solutions deals.

• 42:35Speaker 00

  The platform enables us to get to that deal partner that we don't know because, oh, we're also an LP. Gee, oh, hey, take my call. Generally speaking, I'm not a competitor. There's a part of our house that is an investor. They're going to pick up my phone call. And it's incumbent upon my team to figure out, build a relationship. If you couple the LP relationship, no one gives LPs free money, but access, trust, non-competition. And then our ability to get deep in industries and then liaise with deal partners. We constantly outbound them with, hey, I noticed you guys were trying to do XYZ last year. Do you want help? Or have you thought about getting liquidity in something? A lot of times we'll actually have great data on things. If I call up and say, hey, my name is David. I would like an 18% convert.

• 43:19Speaker 00

  That's not a very attractive pitch. If I call up and say, hey, here's five pages of reasonably thoughtful stuff. Take a look at it. Here are the last 10 deals that we've done. That gets people thinking. There are bankers involved, but when you're doing these hybrid deals, it's not an auction because you're still going to be invested with that owner in the company. They don't want anyone in the boardroom with them. It's a narrow handful of people they want to do business with. You want to be one of those one or two calls because they're only going to call a couple of people. That's how it all works together.

• 43:49Ted Seides?

  As your team and the other people in the organization are teasing out what might be an opportunity and there's some time sensitivity to it. What are the couple of signposts of what will get your attention as a deal that you might want to dive into?

• 44:05Speaker 00

  The first thing when we're sitting down as the portfolio manager for our business, if I don't understand what it is in the first two hours, there's no chance we're doing it. I'm not saying that I'm any great genius. I'm old and I've been doing this a lot. I've seen a lot of these business models. If I can't figure out what it does, or I have to make a bet on technology or a bet on some commodity price, it ain't going to happen. Then we'll look at things and say, do we have any view on the three or four major top line trends here in this space? Some industries we're not very bullish on, some we think are more attractive. Start with that. There are certain spaces we're not going to touch. I don't have a background in retail. I'm not going to go charging into a massive retailer and say, gee, if same store sales were higher, it would be great.

• 44:47Speaker 00

  So basically something we understand, we'll look at the business and say, okay, what are we doing for it? If you look at the two use cases for what we do, it's generally M and A or it's return of capital and start with M and A. If it's small enough, a private equity owned company will use leverage. That's most accretive to its equity. However, if something gets big enough and they need equity, it can be difficult sometimes for them to invest in a company that they have marked up in the same fund and write equity check to go do that. If it's a large deal where they need significant equity, that's more challenging for them. We like that setup because typically bigger things are being sold by someone else and there's time pressure. So someone wants to do a large M and A deal, needs some form of junior capital, has structural

• 45:33Speaker 00

  reasons why they can't write an equity check. Those are about half of our deals. It's also something that has done well. Generally speaking, it's probably in the top 10 to 20% of what they own. And their view is whatever I'm buying is going to help me exit. In two, three years, because it's going to improve the story. Maybe there are synergies. Maybe there's something. Maybe it can help us go public. Whatever it is, that's how the puzzle pieces fit together. We like that business a lot. Those investments can be preferred stock. It's something that's just accreted over time. We're going to get paid for saying, you guys are showing up at an auction. You got competition. Here's 350 million bucks. This is my rate of return. It's hard for them to bid five people off each other. And at the same time, call competitors that are in the business who might be bidding on it. That's been a business we're in. That's not an equity bet.

• 46:15Speaker 00

  All we're assessing there is my detachment point in the structure. At the end of the day, if you think that violence at the Holt Kova company is a good idea, it's not. You want the equity to be successful. It may not earn 27%, but you want it to be positive. Your thesis is I have a lot of value to eat into theoretically. You have to be able to eat into something. And if it's a zero, congratulations, you're also a zero. I don't think people understand that concept. Is this business saleable in a couple of years? What is the thesis? How Herculean are the assumptions? This thing they're buying, do they understand how to integrate it? Is the team good at this? Have they done it before? Simple things like that. You can assess, does the cost of capital make sense? The deeper you are in a structure, the more you should get paid.

• 46:59Speaker 00

  The other business is what I call the return of capital business. I call it the DPI business, where a sponsor says, I have a winner. I'm going to keep compounding my money, but I have people telling me to give money back. I don't want to sell this company because I still think we're going to make money. There's a way for them to enter into partnership with us. We'll buy 20, 30, 40%. They'll take that money. They'll give it to their LPs and we'll say, there's one small catch that I'm going to be structurally senior to you. And I want a minimum multiple of my money because you have a lower basis than I do. I need to catch up. That's generally how it's presented. Those are typically converts where you're buying something, the greater of some minimum multiple or the value of the equity. That is our hardest business by far because private equity isn't cheap. And you're sifting through a lot of assets.

• 47:42Speaker 00

  If you're doing your job well, you have to believe the convert has value. The worst thing possible to do is, well, I think this is overpriced. It makes no sense, but I have a one, five. That's a good way to lose money because you're going to be misaligned from the get go. And enforcing liquidity rights that you have in documentation. Good luck. You have those things. People talk about forced sale rights in these documents because typically you'll have a forced liquidity right. You don't walk into a conference room and say, sell. So how it works, typically the management team has to be on board. The owner has to be on board. If it's not going well, that's not going to be a robust auction. If someone knows it's a forced sale, you have to think ahead and you have to think about being reasonable. We do that business occasionally. It's not a massive part of our book. It's about 35, 40%. We've got to be really selective and we have to have a thesis behind what we're doing.

• 48:27Speaker 00

  By far, that's the hardest business that we're in.

• 48:29Ted Seides?

  Is there anything else that's interesting that falls into the type of deal structure you do?

• 48:33Speaker 00

  Occasionally we'll do a new buyout. There are some terrific direct lenders that have the ability to do preferred. It's an auction. There are five or six guys competing on it. I'm going to back all of them. I'm going to run five trees. We're going to sequester information. No one's going to know what each other's doing and we're not in that business. People are wonderful at it. That's a different business. It's a cost of capital business. The business that we like to do is imagine if you're a $6 billion fund or $7 billion fund, and you want to do a high conviction deal where you're paying 20 times for something, and you've got to write a billion two, a billion three equity check. That check is large existentially for you. And ultimately, you're going to syndicate it to your limited partners. Before that happens, what do you do? Sometimes we'll come in and say, hey, listen, this is a big check. We're going to over commit in preferred. The right hold size is 300 million in this company.

• 49:18Speaker 00

  We're going to commit 500 or 600. There's different costs for those levels. The bigger the number, the more equity like return is and down it goes. People, when they're in a bidding contest, I'm like, use me as your slush fund. If you need another 50, go ahead. That's very valuable to someone to know that you have someone who can move very quickly and will have a minimum hold. You can syndicate me out until you hit X. There are a couple of partners we've done that with where we are their partner. We're the silent equity partner, but we have a structure behind it. We've done those a couple of times. That's the universe we're in. The one thing I mentioned that we get looks at, we don't want to do bailout capital. We see every one of those deals. I'm sure there are smart people that do it and I'm sure that there are wonderful funds, but it's difficult to analyze those things unless you are an expert

• 50:03Speaker 00

  or have operational partners in the industry with a specific view on what the 90 day plan is. Once you delever, just sitting in Excel saying, wow, if margins got better. I don't think that's a good way to scale a fund and go through life.

• 50:15Ted Seides?

  How do you think about what your portfolio looks like, of the number of names, diversification?

• 50:19Speaker 00

  When we set up these funds, they're private equity-like. They're drawdown vehicles. We don't leverage these portfolios, so there's no third-party leverage on the funds. And that's important for a couple of reasons. I couldn't get attractive leverage even if I wanted to, because none of the companies pay interest, they're not senior secured piece of paper. My advance rate would be nothing. I would go through all of this mishegas and get no incremental return. If you believe that you are an alpha strategy, I think I'm getting excess return for doing this. I have some edge, whether it's structural, who I am, whatever it is. At the same time, I want to balance that because these names are not going to be 5X's or 6X times our money. If you look at a PE fund, the way it's constructed, sometimes it will have seven names. Have a seven-bagger, have a three-bagger, have things marked in the middle and some things aren't so good.

• 51:03Speaker 00

  And those offset. We're playing between 1.5 and 2.5 times your money, somewhere in that range. So you want to have reasonable diversification, 25 to 30 names. You're able to withstand a left tail event. You have to be able to do that, especially with no leverage. But you can't have 100 names, because then you're just doing anything and you're participating in clubs. All of these deals, we typically author them and we syndicate them to our own investors, our own platform. You have to have enough scale and have to be able to do 500, 600 million. But you have to be able to size it appropriately in a fund that if something, God forbid, goes wrong, it doesn't destroy the entire portfolio. It's that happy balance. And that's what's hard, because you've got to find 25 high conviction ideas. And you will scale things based on risk. If something is a massive conviction, love it,

• 51:47Speaker 00

  someone gave me a free lunch, that's a 4% name. And if something has more drawdown probability, it's going to be a 1% name. You're doing less of that, but you're also thinking about that. And you're thinking about what factor risks you're exposed to. I used to laugh whenever a drawdown private fund has a risk manager. I'm like, well, what does that person do? Because you don't hold cash, you don't hedge. Are they on your investment committee, telling you what not to do? Because all of your risk comes from sizing the bets and what you're investing in from the get-go. Once you're in these names, they're private. You can't say, whoops, made a mistake, I'm going to move on. It's difficult to do that, especially when it's a name that you authored and you have your own investors in it. You can't just do that willy-nilly. You're thinking a lot about risk management

• 52:29Speaker 00

  when you're constructing the portfolio real-time. There's very little you can do. Once you're long these names, you're on the board of the company. You've got to be really thoughtful about how many risks am I exposed to that are the same?

• 52:43Ted Seides?

  What's the difference on the margin between a name you'll invest with and put in the portfolio and one that you decide not to?

• 52:49Speaker 00

  I've got to believe in the top line. My least favorite theses are value traps. I'm going to fire X, Y, and Z, and I'll be able to create an X multiple. Other people may do this well. In my 31, 32 years of doing this, that's always gone poorly. I will take top line over terminating people, cutting costs all day long. I have to have some conviction. Why does it grow? Explain to me why. And it's not just, well, I took an Excel and I wrote 1.06 and I kept multiplying it. No, I mean, how do they sell this stuff? Do they have real pricing power? Who are their customers? If you look in business services, they're sales organizations. I'll spend a lot of time saying, okay, if I'm making a bet on this company's ability to sell stuff, are they well-run? How do the salespeople get paid? How does it work? It's top line.

• 53:32Speaker 00

  Every single time when I'm making an investment, I'm never going to pick a point estimate on a number. Where is my confidence interval around 7% to 12% growth? That's difficult to do, to grow 8% or 9% consistently over four or five years. If you're underwriting that as your thesis, God, you got to have data. Not only data about looking backwards, but what is someone telling you that gives you that confidence going forward? What are you pointing to? That's the hardest thing. The other piece for me is who's running it? That's so important. We've made investments in large companies where the management team owns half the business and they're extremely wealthy. They want to hop on the phone every two weeks to talk to us because they love it and they live it every single day and they're animals. That is so powerful to have a partner like that, especially someone who's a founder

• 54:16Speaker 00

  that built the business from scratch. And to this day, regardless of how much money he or she has in their bank account, they love it. They want to do it. That's who you want to partner with. Having a financial guy as chairman of a company? I don't want that. I don't want someone on eight boards. I want someone who lives it and breathes it. On the margin, those are my two things.

• 54:35Ted Seides?

  How easy is it to tease that out on the people's side?

• 54:38Speaker 00

  It's hard. I have many flaws. I don't know where to start to describe them. My wife could give you a pretty long list. One thing I'm okay at is being pretty direct with people, but doing it in a way that doesn't offend them completely and getting answers. I like to say. Sit down with people and say, why do you do this? Tell me about how you built it and what you were trying to do and tease it out. It takes a while to tease out, to figure out like what makes someone tick. When I go and meet with management teams, I make sure our team's really prepared. If our team spends the first management learning about a company, we failed. You want to be able to start asking questions where people are like, wow, these guys actually spent time learning my business. It goes a long way because people are like, wow, they're interested in what I do for a living.

• 55:22Speaker 00

  Step one, if you start building that confidence early on, they'll start telling you things. And you're not being argumentative and antagonistic. You're like, listen, I want to learn how this works. I'm interested. You can slowly tease out what gets people motivated. I've been in lots of deals where after talking to someone over dinner, I'm like, you're checking out. I'm writing you a $500 million check and you want to retire. I don't think we're going to do this one. You have to figure that out and people don't come out and tell you that. They give you cues and you have to build up those cues and sometimes you're wrong. It's a subtle skill that's taken me a long time to figure out.

• 55:53Ted Seides?

  When you're one of a few people able to provide this type of capital in the private equity ecosystem that itself isn't having easy liquidity, how do you think about the exit strategy for your deals?

• 56:06Speaker 00

  If you're doing that M and A deal, you're making a wager that that M and A deal is going to be transformative somehow. They're going to realize whatever synergies, they're going to create a different narrative about top line growth. They're going to jettison some part of it that's slower growth, something that's going to change the narrative that maybe will appeal to the public markets, that maybe will get a strategic interest in it. That's part of what you're doing. And the second thing is when you're doing what I call the DPI trade or returning capital, sometimes those companies have run processes and they weren't able to sell the company. And you're going to come in and provide them partial liquidity and it's like, well, why am I so smart? Because they just try to sell it and why do I think three or four years will be better? I wasn't born yesterday. You've got to do a lot of soul searching as to what's going to be different.

• 56:51Speaker 00

  It can be things from when they sold it, the two or three best strategics were doing whatever. That could be part of your thesis. They were tied up. It could be that there were certain macro things going on, or that they had leaked valuations that weren't realistic that caused people to stay away from this process. Maybe they need two years of proof of concept of one of the business lines that they're pointing to that no one believes yet. You've got to grab onto something. When these checks get to be big, a billion and a half, $2 billion for equity, these problems don't go away. That's the hardest part of the business because when you're doing straight preferreds, oftentimes they just refinance this out. You are a bridge in the structure between six and eight times. If the company does it all well, they're very quickly going to eliminate 16% money.

• 57:33Speaker 00

  They come to you for speed and maybe they want discretion so they're not going to compete you across the world. There are these mega preferred deals that get done that are a billion and a half dollars where the company has syndicated loans. And someone will say, you know, I don't care who's in it. I want to syndicate it and I'll race to the bottom. Fine, but when you're doing something where you're on the board of the company and you have an equity option, you've got to have a view on why it didn't sell now. We've had examples where there were a lot of pro forma adjustments in EBITDA. And people said, I'm not going to pay this multiple on this pro forma number. We had made a bet that they're going to come off over time and the number is going to be more clean. There's different things you can make investments predicated on, but you've got to be really thoughtful.

• 58:15Speaker 00

  More and more discussions with my team, we'll look at a deal like, how are we ever going to get out of this? This doesn't seem like a good idea. This seems like giving someone a check and having the same problem in four years. That's what you're going to be all over.

• 58:25Ted Seides?

  What happens when something goes wrong?

• 58:27Speaker 00

  You don't sleep well. You question your competence. The most important thing is, is the business worth saving? Is there residual value? If there's no residual value, meaning past the debt and you've made a fundamental mistake, don't put money in that. That's the hardest thing to do. Everyone's guilty of it because psychology is consistent. No one wants to admit mistakes and say, wow, I messed up. Thankfully in our business, we haven't done that yet in these transactions. We've done 51 of them. Now, there've been instances where something's happened. The company needs capital for whatever temporal reason and it looks messy, but the overall franchise Is valuable. That's where some people don't understand how incentives work. You can't take the majority owner of a company and say, you're a zero. I have all the value at the holdco. Have a nice day.

• 59:12Speaker 00

  Are you going to manage the business? Are you going to show up at every board meeting? You just told the CEO and his team or her team that they're zero two. Come on, think it through. You've got to figure out a way to say, okay, if we have to inject capital in this company for whatever reason, and I'm more senior, I probably have to write a smaller check than you. Or maybe we collapse the structure and we all own the same thing. And we'll figure out how to apportion value. Maybe Mr. Sponsor, I'm okay if I'm in front of you. If I get this minimum return and I'll give you upside above certain rate of return. You've got to focus on incentives. You can't just say, you're a zero, I'm senior. It's not going to work out. People pitch that. I'm like, I don't know what deals you've looked at. That's not how it works. These aren't always friendly, nice conversations, but you want to get there.

• 59:56Speaker 00

  I've had instances where people like, wow, you know, I'm like, no, I'm being direct because you weren't direct with me. What I value the most is someone tells me, we got a problem. We got to go figure it out. It's going to involve a check. Okay, as long as I know, but when other little games happen, eventually we all get to a good place. That's the most painful thing. And I tend to get involved a lot because my background wasn't complicated bilateral negotiation. Fortunately, those have worked out, but those are difficult because you're writing a check. You still have to have conviction that the franchise isn't broken. That there's value there, that whatever's happening is because of some exogenous temporal thing. And that you need that capital to get through it. It's hard to get conviction around that. The human brain is a very fragile thing. When things are going wrong, it's very easy to be negative.

• 1:00:41Speaker 00

  It's very easy to say, oh, this whole thing sucks. Terrible, terrible, terrible. It's amazing how things can turn. We were involved in a company that we injected a tremendous amount of capital and with the sponsor in February, March this year to deleverage part of it because we were already in it. People are already pitching going public. It's six, seven months later and it's amazing how short memories can be. I wasn't in March thinking about this company going public. That's the art form.

• 1:01:04Ted Seides?

  As you look at the strategy, what do you think is your most important point of competitive advantage?

• 1:01:11Speaker 00

  First is the funnel. Eight years ago, the team was much smaller. Sourcing was me and another dude. We now have done a fantastic job, not only covering the private equity world, industry dives, people, but all the relevant bankers as well. I look at some big brand names in the space and our sourcing compared to some of them is a lot better because we've gone through that journey. We had to transition our business from being a me too ops fund to being someone who does this and somebody does it at scale. The most important thing for me was get sourcing right. I'm not going to win if I don't see everything. That is where we're really differentiated. As a corollary to that, because we don't have vulture roots, I can teach my team, do not be antagonistic.

• 1:01:55Speaker 00

  Do not fight over stupid things that don't matter in documents. There are four things that matter. The ability to put debt on top of you, the ability to take assets away, the ability to take money out of the system, the economic terms of your agreement. Don't fight over little things just to fight. Getting rid of that mindset and also being not recognized as a competitive force. I'm not someone they compete with in other buyouts. Because the same guy who runs that firm runs that business and the buyout business. In 2023, when some of our competitors that were owned by buyout firms were very negative on the world. People had this view that rates would go up forever. If I can fix my return at 18%, I can make money because everyone else thinks interest rates want to go up forever. I'll do that. Very simple thesis. Sometimes people got caught in their own nonsense because of their connections. The independence is very important right now.

• 1:02:40Speaker 00

  There are very few people that are truly independent operators that can scale to 700, 800 million dollars in a check that are not impossible to deal with. That informs our sourcing because the more and more you behave like that, the more and more people pick up the phone and call you. That I would say is our single biggest thing. Finally, is philosophy and humility. I have realized over time, when you get into trouble doing this stuff, you take risks that you really don't understand. You say things like downside protection when the thing has got massive inherent volatility and just being humble enough and like, I don't know what I'm doing. This seems like a bad idea. I want my team of people that are smart, that are aggressive, but I want them to advocate for risk. The single easiest thing to do is be risk averse.

• 1:03:25Speaker 00

  Anyone can do that. Oh, that's a risk, that's a risk, that's a risk. The skill in investing is to want to take risks and to understand how to quantify those risks and to say, am I getting paid appropriately for them? Now, that sounds like a lot of mumbo jumbo. Finding someone at a mid-level or a principal level that wants to take risks and knows it could impact his or her career is rare. As long as they're responsible and as long as they actually have data, because I'll have guys on my team, gals on my team, that will call up and say, we should do this, we should do this, we should do this. And I'm like, I hate it, it's terrible, it stinks, I don't like it. Then they'll say, did you read it? And I'm like, no. I'm like, please read the stuff I sent you. That's what you want. The final point would be, I want people to think that I'm an idiot, my team.

• 1:04:07Speaker 00

  I want them to think they can do my job and they don't have it for now. That's important to me. I don't want people to think, oh, whatever David says, that's terrific. I want them to challenge me.

• 1:04:17Ted Seides?

  I'd love to get your sense of risks of the strategy, but also in this broader ecosystem of what you're seeing in the lending environment as you see so many of these deals and only a few of which you feel worthy of providing capital.

• 1:04:29Speaker 00

  I think in direct lending, people learned a lot from the GFC. People have been thoughtful about leveraging these books. I'm not a CLO guy, but something like 93% of the CLOs formed before the GFC had positive equity returns. The reason why I mention that is that CLOs actually have a good structure. People that don't understand say, oh, they're a forced seller. They're not. There's a specific regimen for how cash flows get diverted and people are not forced to sell assets at sentiment bottom. That's why you would think that 10x levered vehicles that bought LBO loans pre the GFC, no one would think 93% of them would have positive equity returns. That's because the structure was good. They weren't compelled to sell collateral when loans were trading at 65 cents. Structure is very important.

• 1:05:13Speaker 00

  A lot of these direct lending funds aren't financed with TRS, aren't financed with overnight repo. They're more thoughtful leveraged facilities. A lot of the funds have long duration capital. Some are permanent, some are 12, 13 years. As long as the leverage provider, you have degrees of freedom. You don't have people say, oh, party's over, you gotta sell all this stuff in a fire sale. That's when you blow up. Structurally, the industry's in a much better place from leverage perspective. Do I think there's going to be an implosion in direct lending? No. Like everything else in life, there are going to be defaults and there will be some bad recoveries. People that were more aggressive are probably going to pay the price. The good thing is the distribution of outcomes is relatively narrow.

• 1:05:54Speaker 00

  If everything goes well, it's going to be that levered return that everyone talks about, the double digit. Things go poorly, it's tough to lose money in these. It's really tough if you're diversified and thoughtful about leverage to lose money. It's possible. I'm sure someone's going to do it. There's been a lot more sophistication about what they're doing, diversification, all that stuff. Question is, are you getting paid adequately in credit spread? That's an asset class attractiveness question. If you're making a bet on rates, there's this thing called money markets you can buy. And no one charges you one in 10 for that. When you look at that asset class, what are your expectations? What's going to happen with rates? Our current administration has made their point very clear about where they want rates to go. What is your expectation about defaults? Now, you're starting to see non-accruals and defaults pick up in a lot of these public vehicles.

• 1:06:39Speaker 00

  There is a 30-year history for leveraged loans. What defaults and recoveries have been. It's up to you to decide, are you going to use that as a proxy? Is private lending different? I think you can solve for that. There are probabilities where your outcome is not what you thought it was. You're locked up for a long time and it's not 10%. It's something else, but I don't think it's bad or catastrophic. It's easier with smaller pools of capital to buy smaller companies. To make returns that are usual private equity type returns, 20s, 25%. Because there are multiple sellers. You can do real M and A that impacts your business. If you have a company with 700 million of EBITDA, it's hard to do M and A on an add-on basis, going to have a real impact. Whereas if you have 15.

• 1:07:21Speaker 00

  Mid-cap, larger-cap private equity, you're going to have to think about return expectations. What is that asset class going to do? I'm not going to quote numbers, but if you're rooted in 26% net, you're going to have to think about things over time. Do I think that some of these vintage are going to have challenges? Yes. On the other side, now it could take many years, but there's opportunity. Eventually, capital will have to get returned. People will have to be more realistic. And if there is a real market cycle. Maybe evaluations will get adjusted. Right now, it's challenging to transact in that market.

• 1:07:51Ted Seides?

  A lot of the investments you talked about are structures for this moment in time. And it may last several years, but there's no reason to think 20 years from now, we're going to have the same. How do you think about the flexibility inherent in the hybrid strategy of where you think this goes over the next couple of years?

• 1:08:09Speaker 00

  The good news is for the current pools of capital we manage, we're in good shape. The next couple of years, my ability to tell you what's going to happen in four or five years, challenged at best. I'll give you some flavors. Dislocation is awesome for us. If you have your best company and the world's blowing up, are you going to call me or some vulture? Call me. I have a front row seat to that business either way. I saw it during COVID, when a lot of traditional lenders were nervous and they pulled. I'm like, I'll come in. You need capital? 20%. That's a good business. I'm not going to predict that was going to happen or show you four slides that the world's going to end. In that environment, awesome. Hybrid flexed at capital to do that? Awesome. The worst environment for us is 2021. Awful, awful, awful, awful. No one cares about money.

• 1:08:52Speaker 00

  There's a $20 billion IPO every week of a company I've never heard of. People are squeezing cost of capital. Rates are zero. Toughest environment to navigate where everyone's a VC investor. It's difficult because no one cares about money. Will more competition emerge in what we do? Yeah. And it all depends on what returns people are willing to accept for what we do. There are too many people in this hybrid space that pitch unrealistic returns. That you're only being driven by either buying equity in something that has a lot of volatility or taking massive industry or company risk. And you're pitching it as downside protection. That to me is intellectually inconsistent. If you're willing to be honest with your expected returns, there's plenty of stuff to do.

• 1:09:33Speaker 00

  But it could change because more and more people, as these private equity firms have become institutions, not all of them, but focus tends to be more on AUM and growing AUM rather than earning returns in a given asset class. That impacts overall cost of capital. I don't want to tell you what's going to happen in four or five years, but that concerns me. Always does when people get big and rate of return isn't the most important thing. It's their brand name. It's their marketing arm. All sorts of things that get them to be bigger. That's just capitalism. It's what happens.

• 1:10:04Ted Seides?

  Dave, I want to make sure I ask you a couple of fun closing questions. We'll finish it up. What was your first paid job and what did you learn from it?

• 1:10:10Speaker 00

  I was a caddy. I learned a lot. And this was in the 80s. I think a good loop was 18 bucks a bag. You were a self contractor. You didn't show up a set hours. You didn't scoop the ice cream. You could choose not to work. You could choose to be lazy. You could choose to do only one loop. This is all on me showing up and doing this. I was 13, understanding that work ethic. And then second, dealing with people. When you caddy, you see people cheat. You see people talk nonsense. You see people that are incredibly difficult. And they're stuck four or five hours together on a golf course. You learn a tremendous amount through osmosis. Then you learn how to be a good caddy. One of the most important things, some caddies go overboard and talk too much and start telling stories and all that stuff.

• 1:10:53Speaker 00

  But they lose golf balls. My dad, he's departed, told me very early on, never lose a ball, ever. You keep up and shut up until you're spoken to. Always have a wet towel. What do people really care about? They don't want to lose their ball. They want to make sure when they go to grab a club, you're right next to them. If you want to be charming, you do that on the side when someone invites you into a conversation and you can say your witty thing. It taught me to deal with difficult people. It taught me the importance of work ethic. And it taught me there are some basic principles you got to master here. Unfortunately, I play golf. I have played for a long time. I've seen every flavor of caddy. When someone's good, at least I can take care of them because I used to do it. And I used to do it for a long time. I can realize what a drag it was sometimes.

• 1:11:32Ted Seides?

  What's your biggest pet peeve?

• 1:11:34Speaker 00

  On the investing side is IRR. It drives me crazy. Assuming that capital I give back to someone is going to earn the same rate of return that's still being invested. It drives me up a tree. I've given this big check back and you're assuming you're redeploying at that same rate of return, but it's not. I'm actually making no money. The most important part in investing, last time I checked, is to compound your money over time. That also goes into my other corollary of people that are obsessed with yield. If you need yield, wonderful, great. Have a cash flowing product. However, your return goes out every quarter and doesn't get redeployed. And especially retail investors, I don't understand, like I want to yield. I'm like, so you can pay ordinary income? So you cannot reinvest your capital? If you have dollars to invest, you're not a pension with a liability. You're a person. If you compound your money in something you believe.

• 1:12:18Speaker 00

  Those are the two where I understand if you need cash flow to pay certain expenses. Wonderful. You're retired and you have to have income. Terrific. If you're trying to compound capital over time, why pay ordinary income on something that doesn't compound? I don't get it. I still don't get it to this day. And then just people that are obsessed with IRR. Because in these funds, there are ways to manipulate it. You have to look at multiple of capital and how many years you're stuck and the average amount of capital deployed and then use that as a litmus test versus IRR. That's one of my biggest pet peeves.

• 1:12:48Ted Seides?

  All right, Dave, last one. What life lesson have you learned that you wish you knew a lot earlier in life?

• 1:12:52Speaker 00

  20 years ago, I was a lot less mature about the importance of team. And that's going to sound stupid. I was much more of a loner. I had opinions. I do what I do and I know what's going on. Team schmee, this is all a bunch of gobbledygook. We figured out a society division of labor. It's actually pretty effective. There are people that are better at certain things than you are. What's powerful is getting those different people together to do something. When I built this business over time, it dawned on me, having people with different skillsets, having people with different strengths and having them trust each other. I never would have said those words 25 years ago. And if you knew me, never would have come out of my mouth. That's something I wish I really understood a long time ago because it is the single

• 1:13:36Speaker 00

  most important thing you do is selecting those resources and getting them to work together. Also, the power of positivity. I can be somewhat sarcastic and I can be somewhat skeptical. It's amazing on how Outlook can transform results. If you just think, you know what? It's not the end of the world. I'm going to push through. I'm going to have a brighter perspective on this. It will actually impact the result. Learning that for me was the hardest thing as a natural cynic. It's difficult, but it's powerful.

• 1:14:02Ted Seides?

  David, always appreciate your straight talking insights. Thanks for sharing.

• 1:14:06Speaker 00

  Yeah, thanks for doing it, Ted. Really appreciate it.

• 1:14:08Ted Seides?

  Thanks for listening to the show. If you like what you heard, hop on our website at capitalallocators.com where you can access past shows, join our mailing list and sign up for premium content. Have a good one and see you next time.

• 1:14:23Speaker 02

  All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of capital allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of capital allocators or podcast guests may maintain positions in securities discussed on this podcast.