Jonathan Lewinsohn – Credit Microcycles at Diameter (EP.484)

Jonathan Lewinsohn is the co-Managing Partner of Diameter Capital Partners, a credit-focused investment firm he founded with Scott Goodwin in 2017 that manages $25 billion across hedge fund, dislocation, CLO, and direct lending strategies. Jonathan last appeared on the show five years ago interviewed by Kristen VanGelder from Evanston Capital, and that conversation is replayed in the feed. Our conversation offers a comprehensive credit market update, including Jonathan's take on the business of credit investing, private credit, industry microcycles in AI, housing, telecom, chemicals, and healthcare, competition among creditors, the insurance-driven investment grade market, and the importance of macro awareness in credit investing. Jonathan's blend of investment insights and market opportunities is a real treat, and comes on the occasion of a likely public listing of a Diameter BDC. Learn more about our Strategic Investments: Ascension Data https://www.ascensiondata.co/capitalallocators. 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 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

  What it means is the best opportunity for distressed has been microcycles. Go back during just my career and Scott's career when the muni market got blown up because of some choice word said by a famous analyst after the financial crisis. Even the European kind of double dip recession in the peripheral countries. Then the energy microcycle in 2015, 16, the California power microcycle, which most of California was impacted by and many counterparties. When Amazon and online retail upended mall-based retail and mall-based real estate. Then after COVID, what we've seen in telecom, we're seeing now in housing, we could see in software.

• 0:41Speaker 00

  It means when a whole industry that has a lot of debt is impacted by either technological transformation or policy volatility or both. And handling things when you have a lot of debt is the problem.

• 1:00Ted Seides?

  I'm Ted Seides and this is Capital Allocators. My guest on today's show is Jonathan Lewinsohn, co-managing partner of Diameter Capital Partners, a credit-focused investment firm he founded with Scott Goodwin in 2017 that manages $25 billion across hedge fund, dislocation, CLO and direct lending strategies. Jonathan last appeared on the show five years ago, interviewed by Kristin Van Gelder from Evanston Capital, and that conversation is replayed in the feed. Our conversation offers a comprehensive credit market update, including Jonathan's take

• 1:40Ted Seides?

  on the business of credit investing, private credit, industry microcycles in AI, housing, telecom, chemicals and healthcare, competition among creditors, the insurance-driven investment grade market, and the importance of macro awareness in credit investing. John's blend of investment insights and market opportunities is a real treat and comes on the occasion of a likely public listing of a Diameter BDC. Before we get going, have you noticed that airline travel takes a lot longer these days? Security lines go on as far as the eye can see, and that's even with pre-check, clear, or the pre-check, clear combo. And flights seem to get delayed regularly for no apparent reason.

• 2:25Ted Seides?

  Well, the next time you have even an inkling of a delay, and long before you have to board, de-board, board again, and sit on the tarmac for an hour before you leave, might I suggest you fill that idle time with successive episodes of Capital Allocators? By the time your plane leaves, you'll have gotten through at least two or three amazing episodes, and probably made friends with your equally frustrated neighbor in the seat next to you, who may not have had the benefit of listening until you tell them to. Make a new friend, productively pass the time, and find your way around the world smarter than you started. Thanks for spreading the word. Capital Allocators is brought to you by AlphaSense.

• 3:08Ted Seides?

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• 3:49Ted Seides?

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• 4:33Ted Seides?

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• 5:14Ted Seides?

  so your talent can shift from managing old technology to materializing new ideas. RidgeLine helps asset and wealth managers understand and improve their firm's growth trajectory. To see how your firm compares to 16,000 of your peers, visit ridgeline.ai/trajectory. 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

• 5:55Ted Seides?

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

• 6:30Ted Seides?

  Jonathan, great to see you.

• 6:32Speaker 00

  Good to see you too, although people will only be able to hear us, which I guess is lucky. Face for radio, works in this medium. Thanks for having me back and where I belong.

• 6:42Ted Seides?

  It's been several years, probably five years since you came on the show. And I think it'd be fun to start with how diameter has changed over the last five years.

• 6:51Speaker 00

  It's hard to remember exactly in time. It's like with your children, what were they like when they were seven? When you start a business and build a business like I have with my partner Scott Goodwin, the comparison to children is unfortunately apt in many ways. Good thing is Scott and I continue to do what we've done almost every day since 2017, which is manage our hedge fund and our dislocation fund, what we call the son of our ecosystem. I spend most of my day going through credits. I would say 80% of my time is going through investments that we're considering, going through investments that we have. The remaining 20% is talking to our investors and dealing with running the business. I could probably do a better job running the business. The two of us do our best at it, but it's not necessarily our highest and best use.

• 7:35Speaker 00

  I had an old boss who used to call investment firms popcorn stands. From a running the business perspective, sadly, I've learned that he was more right than I appreciated. As a firm, we've grown and what we try to do is say, how can we do things in corporate credit that will complement the hedge fund and the dislocation fund, will not cannibalize it and will not distract us? What we've done most since 2021 is we've built a CLO business. Our CLO business today is, I think on deal 16, we have four deals in Europe in a warehouse. For those who don't know, a CLO is a collateralized loan obligation, which is a levered entity to buy syndicated loans. That CLO business has not only produced excellent returns with a market level of risk,

• 8:18Speaker 00

  but I don't see how we could run the hedge fund and the dislocation fund without seeing the loans first, without seeing all these loans that come through the CLO. It's a seamless complementary part of what we do and really helps everything in our business not only be relevant as a capital solutions provider, but learn all the names that are going into the levered loan market. And the levered loan market has changed. As high yield has become higher quality, levered loan market is often lower quality. That's been a big part of what we've done. You may not be aware, you are constitutionally required to have a private credit business. If you are on credit, it's required. The Supreme Court has said it. We have a direct lending business. It's CLO we knew we would do from day one. Direct lending, the business evolved.

• 8:59Speaker 00

  What was once a niche part of markets, doing healthcare, software, business services, is now a key part of what we call levered finance. And deals go back and forth. We've built great direct lending business. Scott and I don't run that day to day. Same thing with the CLO. We have other people running it minute to minute. We sit on the investment committees for it. And we've built that direct lending business into something special. Direct lending is one of these things. Bill Simmons, the Podfather, he's a sports podcast that I like to listen to. He has this thing where he says, overrated, underrated, or properly rated. Direct lending, which is a big part of what we do now, got very hyped up. Everyone's saying, oh, you have to do it, whether it's allocators, investors, GPs.

• 9:41Speaker 00

  And now it's gone all the way to the point that people are so afraid of it, they miss what's great about the business and what it does for everyone involved. It's now underrated from being perhaps overrated and too overhyped. Today, Diameter is a hedge fund, a dislocation fund, a direct lending business, a capital solutions business, which we think of direct lending, top of the capital structure, pristine situations. Capital solutions is when there's a problem that needs capital. It's one of the rare things on Wall Street that the words actually mean what they mean in real life. That's a big secular trend because there's a real need for that. We also have a few other things, but the key is, does it complement? Does it not cannibalize and will it not distract? If you see us running a Chinese equities business one day, you should give me a call and say, how does that fit in?

• 10:25Speaker 00

  I can't imagine we'd be very good at it either. It's a bigger firm. I'm happy to say that Scott and I spend our day much the way we did before we had these other products, and we're better because of the other products.

• 10:35Ted Seides?

  I'd love to double click on private credit. It has come to be this very broad encompassing category, can mean a lot of different things and a lot of different assets. I'd love to get your perspective on direct lending, capital solutions, and other areas that you've chosen not to participate in under this broad umbrella of private credit.

• 10:54Speaker 00

  Let's step back and think a little bit about history. If you come out even before the financial crisis, you have people making private direct loans. You have people, particularly in middle market parts of the world, that weren't being properly paid attention to by the large banks. Where my history and Scott's history with it, really coming through the financial crisis, you had a problem where you had too many funds who'd been making direct loans all across, whether they were good loans or hairier loans. Everything got in trouble during the financial crisis and they were doing it with liability structures that didn't match. All of a sudden, if you were lending out of a hedge fund and you had to mark things down and you were getting outflows, it was a terrible situation because you had to sell good things at a significant discount. What came from those ashes was an industry

• 11:37Speaker 00

  that matched assets to liability duration. You have funds that grew up post the financial crisis, really doing middle market lending. It was needed in a place of the market that couldn't necessarily get the attention for levered loans or for high yields. It got almost too breathless. When we were going into the industry, I was reading everything I could on it and I came across a paper from a competitor that said 2010 was a very important year. Steve Jobs announced the introduction of the iPad, which transformed work and the first unitranche transaction was done. That's crazy, but it was actually, to go back to the overrated, underrated, really important evolution in finance. To be able to step in for middle market companies, whether sponsored or non-sponsored,

• 12:21Speaker 00

  particularly in less cyclical parts of the economy, and add more leverage in a period of time where banks were limited in how much leverage they could do and work with the borrower in a long-term relationship. Not just, hey, we're doing the deal. We'll syndicate it. Let's move to the next. Work with the borrower when there are problems, when they need more debt, when they want to do important M&A. It became an asset class that worked for borrowers, worked for lenders because you got a little more spread because of the liquidity and because of the more leverage and created a new asset class for allocators to not only diversify their portfolio, but reach the type of companies they couldn't reach before. Direct lending has now reached the point because of a few, I think the term de jour is cockroaches. Because people have invested in it and it's Wall Street.

• 13:07Speaker 00

  And so they know whenever there's a fad that grows up, it eventually implodes terribly. They're trying to say, oh, is that going to happen to private credit? The good news is private credit is not a fad. It's been around for a while. It's still a relatively small part of the levered finance market. It's now hit underrated. To answer your question, the best way for people to divide private credit, which can mean so many things, is direct lending is top of the capital structure, often to sponsors, more and more to non sponsors as well, usually for M and A or event transaction. Private credit overall includes more things. It includes direct lending, but also capital solutions. Imagine that you're a private equity sponsor that has a business that was bought in 2021. It has a lot of debt and didn't fully grow into its capital structure. This is a big secular trend.

• 13:52Speaker 00

  It has coupons that look like they're from a bygone era. All of a sudden, you wake up in 2026, you can't refinance because you can't pay 11%. You need a capital solution, which might be junior capital, to help you bridge the gap to pay down debt. I was with a large LP overseas recently. I was talking about this secular change that sponsors need help dealing with 2021, 2022 vintage deals. She said, oh, come on. This is the latest thing from managers. You can't raise anymore in direct lending, so now you're raising capital solutions. She said, I apologize for being cynical, but I'm cynical. I'm never one to push down cynicism. I've made.

• 14:33Speaker 00

  You look at my Instagram feed, it's just memes of comedians being cynical, not to mention my personal humor. But I said, how can we quantitatively demonstrate what we're seeing, which is a flood of these opportunities? So we went back and looked at the syndicated loan market and said, let's actually look at deals by day. Every day that we have a deck going back to 2021, how much leverage? And what was the debt service coverage ratio? Then let's plot it out on a graph and see what were leverage of those deals? Were they higher or lower than current deals? And what was debt service? What we saw amazed me. Sure enough, those 21, 22 deals had a lot of leverage and interest rates were really low. The future deals that came afterwards had less leverage, have worse debt service coverage.

• 15:16Speaker 00

  If people are sick of hearing about direct lending, our argument is you shouldn't be. It's a great asset class, but this capital solutions secular trend is coming down the pike where people can offer actual capital solutions to LPs. For us, it mostly has meant direct lending. We've been doing it for almost three years. We've done over 70 deals. As I like to say, no defaults, which of course we don't have enough track record for. We're proud of the team and the record. The key is, do you do risk management? Where there might be problems in private credit, what we're most proud of at diameter is we risk manage everything, including direct lending.

• 15:50Ted Seides?

  As you look at this massive growth in private credit and direct lending broadly, it's all happened untested, not just the three years you've been doing it, but we haven't had an economic downturn when this surge of activities happened. As you look out of what risks could come from this space, what do you see?

• 16:10Speaker 00

  Of course, we should all appreciate that the risks that hit are usually not the ones that we're worried about. Those of us who lived through the pandemic, of course, appreciate that better than other generations of investors. The irony is that people have been worried about private credit for a while because it's a fast growing asset class. The worry was cyclicality. Oh, when you get a recession, this hasn't been tested. Right? Everyone's always terrified of recessions everywhere, particularly in direct lending. So what did the people who were running direct lending business do? They prioritize non-cyclicals. There was a period of time where there were a lot of energy loans in direct lending products that didn't work in 15, 16. And so the portfolios morphed towards safer things, business services, healthcare.

• 16:54Speaker 00

  And then the elephant in the room, software. Software was amazing because non-cyclical, mission critical. If I had barged into your home in the middle of the night three years ago and shaved Taken you from a slumber and said, Ted, there's a recession coming in the US, but you must own something in corporate credit. What do you want to own? Before calling the police, you would have said, that's obvious. I want to own something in SaaS software related to cybersecurity. Because no matter what happens, no matter what recession we have, JP Morgan, Coca-Cola, Goldman Sachs, they're not unplugging their cybersecurity. Now, fast forward to last year and look at the syndicated loan market. Amongst the worst performing SaaS software loans,

• 17:40Speaker 00

  security names RSA, Avanti, McAfee, Barracuda. They'll have their own issues going through LME. How is that possible? How is the most successful place in the market to hide from cyclicality the worst performing? The reason is that many of these cybersecurity type of businesses didn't have to innovate. They didn't have to create a cloud solution early. Because who's going to take the risk to unplug them even for a second? What happened is native cloud companies came in. They offered a solution, said, don't unplug your existing. Plug us in on a new pipe. See if we work and then unplug. We have now a decline in some of the legacy software providers. It's not only in security. It's everything from software to run college courses to software for auto dealers.

• 18:24Speaker 00

  Now, let's think about AI, which is amazing. What does AI do very well? AI standardizes non-standard data sets. It can look across things. And what almost every SaaS software loan that's in the direct lending portfolios do? It either standardizes data, standardizes workflow, enhances workflow, data visualization, workflow standardization, visualization. AI is great for that. These are mission critical software products. They're not just going to be unplugged overnight. But someone comes along with an AI solution, says, don't unplug. Put me in in a new pipe. All of a sudden, you're in the same position that legacy on-prem software in defensive industries was.

• 19:07Speaker 00

  Now that I've been spending time on Claude Code since my Twitter feed in early December said that if I didn't, I'd be out in the cold. I've been building things and I don't have a coding back. Background. Once you go from buy is much easier than build to hey, build is something that all organizations can do. What does that mean for a software ecosystem that has sold itself? So that's a long-winded way of saying there are many amazing software companies. To say that all of them are going to collapse is ridiculous. Many of the sponsors who do it are the smartest people around, but you do have 30% of direct lending in the software space. We've spent a lot of time making sure that we have sub 10% of our direct lending business in that space. Because what creates a micro cycle in an industry?

• 19:52Speaker 00

  A lot of debt meeting technological change or policy volatility. There's a lot of debt in software. Boy, oh, boy, is there a lot of technological change. What we'll see in direct lending is a recession could challenge it. Direct lending would do quite well in recessions because of the asset liability mismatch is gone. Because you're working closely with sponsors. It would do quite well on a relative basis. You want to own nothing in a recession. But the biggest threat is industry concentration in software going to impact portfolios in a way that wasn't expected when they were under it.

• 20:24Ted Seides?

  As you look at the lending activity in SaaS companies and software, what are the different ways that you've seen loans that you think are good loans? And maybe loans that you think are more risky?

• 20:37Speaker 00

  The hard part to that question is you have to answer the AI question, which is one of the biggest questions in our economy to answer. Waiting for Godot, the Samuel Beckett play is all about what is the nobility of waiting? When you're waiting, what are you accomplishing? What's been interesting about the purgatory of the current situation is no one is happy with AI. Everyone wants AGI, despite the fact that our lives are transformed by AI already. We are not comfortable with AI. We want it to be AGI right away. The reason is we're spending so much money. It has to be much better. When you think about what the future is, we like to look back to two analogs.

• 21:21Speaker 00

  Analog one is the self-driving cars. If you spend any time in places like Los Angeles, you now see the Waymos everywhere. They work. There's a debate about just where they will be, how fast they will go, but they work. But back 10 years ago, we were told they're coming any minute. It took a long time. The reason was it was close. It was 98%, 99%. But if you're sending cars out to streets, it's gotta be 100%. It has to be able to deal with deviations that aren't in the model and not kill people while it does it. AI, which works splendidly until there's a deviation. Agents are working well, doing a lot of things, but they're 98%. They make mistakes. AI is not there yet for prime time, so we can't predict where it's going to go. The same thing with the shale revolution.

• 22:06Speaker 00

  We all know that the US is a major producer of hydrocarbons. Shale worked. Talk to everyone on Wall Street who got wiped out in 15 and 16 because it wasn't linear. To answer the question of which software companies are going to have real problems and which are not, I need more of a crystal ball than I have at the moment. But there are things that you can do and look at. For example, if there's currently AI solutions to the problem that their software solves, that's an issue. If there are easy AI solutions, I would say things around data standardization, comparing pieces of data. It's important to consider the AI impact. If bringing in an AI solution

• 22:48Speaker 00

  would dramatically simplify tech stacks right away, you have to be worried at the moment. It's a thing we're studying most. When we go through any direct lending name or any BSL name, we sit and say, okay, how will AI impact this in the near term and in an AGI? And will it actually be able to participate in it? Or is it going to be impacted by a native, a new AI software? In my career, to add a third example, Look back to when Yellow Pages were having trouble because online ads were coming. Directories, Yellow Pages, before and then right after the financial crisis. I remember meeting with Yellow Pages companies and they said, okay, we get this internet thing. I think they used air quotes, but we have sales teams. We have advertising teams. We're the ones who can go around sell ads.

• 23:33Speaker 00

  If we're not going to sell ads in the directories, we'll sell ads online. We'll sell ads on the Google. And we know that didn't happen. So why didn't that happen? Because internet native ad companies rose up to do a much better job of selling ads. You're going to see that across the AI universe, that AI native companies might deliver solutions that legacy software doesn't do or doesn't do easily. That's what we're trying to figure out.

• 23:57Ted Seides?

  How have you looked at the infrastructure of AI? So there's been a lot of big data center build out and some big loans going into that space.

• 24:07Speaker 00

  We've been referring to AI as the super duper micro cycle. We believe it's been the place to invest in stress and distress, thinking about industries that are going through major change. Part of that super duper micro cycle has not only been creating a fun little toy on Claude Code or the LLMs or investing in venture names, but has also been financing power and data centers and other parts of it. We've been at the forefront doing that now for a number of years. Our approach has been a humble one, given the technological transformation that we see. We're not pushing ourselves out on the frontier of what you can finance, but it's a really interesting experiment in capitalism meeting technology.

• 24:48Speaker 00

  The gold standard is financing a box, a data center that is being used by a hyperscaler, being guaranteed by a hyperscaler that amortizes. Then you can feel comfortable that not only do you have a really important company of consequence, the Metas, the Amazons, the Microsofts, the Googles of the world, but you're also getting your money back in an amortizing way. That's the gold standard. There are then deviations from that. Is it just chip finance? Are you financing residuals? We've not financed long-term residual risk. We think it's been too hard for us, but this is America. Everything can be trunched. We've invested. At the top of the capital structure in an amortizing way. There are construction loans that do get done at S plus two twenty five that are just construction.

• 25:33Speaker 00

  There are guys building things that have never built anything before. And the hyperscaler will come on board. Once it's built, you get paid a little more to do that. Or you can go and build with someone who has built one thing, is building a bigger thing, has maybe a NeoCloud customer. The flavors have metastasized and you've got to be detail oriented in the nitty gritty of the deals. What type of risk are you taking? That's going to be a real story as the funding numbers go up and up. And as the IG market becomes more saturated in the amount of debt that it can take from this asset class. The devil's in the details, as they say.

• 26:09Ted Seides?

  What are you avoiding like the plague in that space?

• 26:12Speaker 00

  Once I go on a podcast and say I'm avoiding it like the plague, that means I'll see an interesting deal a day later. And then I worry, there's no such thing as bad bonds, there's bad prices. There's very few things that we won't try to price. We have struggled to price chip residual risk. You're a creature of who you are. When we were very involved in Hertz, both before COVID and then in its restructuring and its emergence. It was a successful distressed debt investment. Can read Hertz had a problem coming out of their restructuring that they had too many Teslas. It wasn't only that people didn't want to rent Teslas. I think people found Teslas interesting to rent. They're great cars. The problem was the residual value was much worse than was modeled.

• 26:56Speaker 00

  Didn't have the history that you have with a internal combustion car of what is a Chevy Malibu going to be worth eighteen months later? After it's gone from MCO to Disney World a thousand times. What I worry about is, do we have any clue what an H one hundred is going to be worth in three years? If we don't have a clue, how do we lend against it without amortization or a guarantee? That's the area that we're least comfortable, but we want to be a place that is a capital solutions provider, that we can price risk. And we're seeing all sorts of different risk that is exciting to price.

• 27:30Ted Seides?

  Want to step back on this concept of micro cycles. What is a micro cycle as you think about it?

• 27:36Speaker 00

  As human beings, as citizens, we don't want environments of upheaval. They're terrible for humanity. As investors, particularly investors who have an aspect of our business, we were interested in stressed and distressed debt. Investing in recessions or credit cycles gives you the type of margin for safety that you crave because you're buying top of the capital structure things at a discount. For a variety of reasons, we don't have those type of cycles as frequently as we used to have. We haven't had a true recession that is coming from outside an exogenous force. Didn't impact it like COVID in a while. Oh, eight oh nine, you had the endogenous buildup of the housing cycle. That was a big investment opportunity.

• 28:21Speaker 00

  And then you have the 2000 recession, but of course, nine 11 played a role in that. What it means is the best opportunity for distressed has been micro cycles. Go back during just my career and Scott's career. When the muni market got blown up because of some choice word said by a famous analyst after the financial crisis, even the European kind of double dip recession in the peripheral countries, then the energy micro cycle in 2015, 16, the California power micro cycle, which most of California was impacted by and many counterparties. When Amazon and online retail upended mall based retail and mall based real estate. Then after COVID, what we've seen in telecom, we're seeing now in housing, we could see in software.

• 29:06Speaker 00

  It means when a whole industry that has a lot of debt is impacted by either technological transformation or policy volatility or both. And handling things when you have a lot of debt is the problem. Part of the reason we've been more bullish on the economy than some others over the last few years is the US consumer and the corporate have been historically under levered. Debt acts as a boot on your neck. You cannot innovate. You can't spend. You can't do things if you have debt. Imagine you take out a mortgage you can't afford, then you lose your job. You're going to stop spending immediately. Because debt operates that way. Microcycles are caused because industries have too much debt to pivot and do the innovative things they need to do because of change.

• 29:51Speaker 00

  Creates enormous opportunities because I don't want to buy a distressed company because it's disappearing. I don't want to buy a Yellow Pages business that is being eaten by an online business. We don't want to buy a mall-based retail business that doesn't have a great reason to exist. You want to buy something that's in a cycle, that's going through something. What a microcycle means is the industry is going to come out of this. We are going to have telecom. We are going to have healthcare services. We are going to have housing. But there's something that has to be worked through. And might you get an opportunity to buy things with a higher margin of safety than you usually do? Because the market as a whole is saying, we're not sure how this is going to see through. People who can think about the asset side and the liability side, restructuring and

• 30:36Speaker 00

  what companies are worth together, get a chance to kick it through that microcycle. We think it's the most important thing to think about when investing in distressed.

• 30:44Ted Seides?

  Take me through housing, something you referred to a few times.

• 30:47Speaker 00

  Housing is a fun one because the US has a large housing market, about 150 million units for a big country. And we've been frozen. We've been frozen in terms of transactions since interest rates started to go up. You might ask why? The modern housing market is, in many ways, 75 years old. We've been through ups and downs with interest rates before. Why did this interest rate move? Which, by the way, even though we've all been moaning about interest rates for a while, from Realtors all the way to 1600 Pennsylvania Avenue, this isn't a historically high interest rate environment relative to other things. What you did have that was different this time, which is that in 2021 and 22, Americans

• 31:32Speaker 00

  were number one obscenely rich. We became the greatest welfare state in the world pretty quickly, and the stock market did pretty well. And interest rates were essentially zero. Everyone in the country bought a house, moved, or refinanced. So you have an environment where a very high percentage of mortgages were at historically low rates. You then have the inflation event and rates go up very quickly as people realize that transitory was a four-letter word. You move from a period of historically low rates to a period of historically high rates, just after you had historically high activity in the mortgage market. And that means you're frozen.

• 32:12Speaker 00

  We go from five to five and a half million of existing home sales down to four. Where we were, by the way, in the financial crisis, which was a housing and solvency crisis. This freezing is a real impact on the dynamism of the country. One problem that Europe has as a monetary union compared to us is that if you are from Lisbon and get a great job in Stuttgart, you're not taking it. It's probably the other way around. You're probably not moving from Stuttgart to Lisbon. It's culturally a totally different place to live. Portugal and Germany, even if it's part of a monetary union. In the US, part of what made us so dynamic is if you live in Columbus, Ohio and get an offer in Cincinnati, that's better, you go. If you live in Las Vegas, you move to Orlando.

• 32:54Speaker 00

  And America has been culturally homogeneous enough to make it feel like, I still live in America, make new friends, will join a church or a country club and in the public school and just roll. We've been frozen. We can't do it because you can't trade a 3% mortgage for a 7% mortgage. So what's happened? Existing home sales go to four million from an average of between five and five and a half. We've dug into it and it turns out that we think about half of those come from deaths, divorces, and homes that don't have mortgages. So we call those the deaths and divorces. We call them non-discretionary moves. Death is self-evident and divorce is theoretically, you could live with your ex-spouse, but you might rather be dead.

• 33:37Speaker 00

  We think that the non-discretionary moves are about three million of the four million, which means we only have a million homes per year where people are saying, hey, I got a better job in Cincinnati, I'm taking it. Or, hey, things are going well, let's get a better house. Or, things aren't going well, or the kids are gone, let's downsize. That is not a sustainable thing. At the moment, population growth is low, so that helps. We also had a boom for a while in housing starts in places that were warm and may have lower taxes. But that is petering out as well. We see housing as this coiled spring. It has to come back.

• 34:19Speaker 00

  There has to be more dynamic movement in the housing market. You have vacancy rates that are historically at levels that you don't see for these periods of time. You see when rates have dipped for a little bit of time, you get extra activity right away. We think the housing market, which is everything from builders to realtors to the place we've been most interested, which is building products, which work for renovations. You've got lots of LBOs in the space, an enormous amount of debt, good companies. Every micro market is different. Some have two or three suppliers, some have four or five, understanding the distribution trains, understanding the liabilities. We see it as a cyclical micro cycle. Then I don't know when rates are going to come down. Everyone has been wrong calling rates coming down for most of the last three years.

• 35:04Speaker 00

  But when they do, you have a very interesting micro cycle on the upside. And you've seen, building products in particular, earnings expectations have really capitulated in 2016, which could create interesting environment for outperformance.

• 35:17Ted Seides?

  As you look at that whole landscape and you picked building products, what are the most important levers in determining where you want to try to participate in the micro cycle?

• 35:27Speaker 00

  Everyone's business is different. There are many people who do equities and so they have a broader universe. We are blessed to be credit guys. We get to be a little slower. We look at capital structures that are over levered in businesses that can make a good return on capital. One thing that we emphasize at Diameter is what is a good business? Some people talk about management, some people talk about margins. For us, we say, let's go back to first principles. What is the return on invested capital for the business? Simply take tax affected EBIT and look at whether it's PP makes sense or the last five years of CapEx. Does the business earn a good return? If it does seem to earn a good return, why? Oh, there's only two guys who do this. They distribute to Home Depot and Lowe's and then through building products distributors.

• 36:12Speaker 00

  That's a pretty interesting business. So we're trying to find good businesses from a return on capital perspective that can get price when things come back. And where the debt is trading at a discount because it's over levered. That's really the sweet spot. Frankly, we don't want restructurings. Restructurings are painful. I've got to put faith in one judge to see the world in a way that we see the world. We'd much rather find businesses that might be over levered today, but have excellent management teams, excellent sponsors that we can work through. On the other side, maybe they need a little more capital. Maybe they need a little relief, can get an earnings bonanza from the microcycle ending. We've seen that telecom has been the microcycle that we've prosecuted the most since COVID.

• 36:55Speaker 00

  That's been incredibly profitable and with limited bankruptcies. It's been about finding companies at an inflection that are about to benefit from AI or are spending a lot of money laying fiber, but that will yield to higher penetration and market share over time, investing in those and then riding it out.

• 37:11Ted Seides?

  When you talked about that analysis of ROI in is it a good business? It sounded a lot like someone who's underwriting the equity would look at is this a good business? Is it going to grow? How do you think about the difference between underwriting a business that's good and underwriting a credit senior in the capital structure at a good price?

• 37:30Speaker 00

  There's many ways to skin the cat. There are plenty of people who are more successful than we are, who look at credit as a credit and say, I'm at the top of the capital structure, I'll be fine. Scott and I and the team think of ourselves as investors. There's something generational here. Distress debt investing was such a frontier, say, at least 25 years ago, even before the financial crisis. You didn't need to really care if it was a stock company or a steel company. You knew bankruptcy, the other guys didn't. That has been competed away and is competed away more every day. Technology helps level the playing field in terms of just going through docs and understanding process. The more deals we have, the more like knowledge we have about what could happen and how we could get screwed. We start as investors. We start with, is it a good business?

• 38:14Speaker 00

  Will we invest in a business that we don't think is amazing? Because we think it's good enough where we are in the capital structure? Certainly.

• 38:23Speaker 00

  But if I look back at places where we've lost money and credit, do they line up in those type of situations more often than I would like? Yes. There are people who say, I only invest in great businesses. I only invest in monopoly businesses. That's not our business. We look at every new high yield deal, every levered loan, every direct lending. But starting with first principles of what makes a good business? Debating that, I ask everyone I interview, what makes a good business? Why is it a good business? People struggle to talk about what it means. And we think it's, are you earning? If you're like an industrial or are you earning return on capital? If you're a financial firm, are you earning a really good return on equity? Such that not only are your assets secure, but you could trade it on multiple of book? And in direct lending, where you can't trade, where you can't get out of it.

• 39:06Speaker 00

  We spend a lot of time saying, hey, do we think it's a good business? Do we think it has the right to earn a high return on capital? Such that it could handle all this leverage? If it goes through a recession or there's technological change, will it come out the other way? That's why we have a differentiated portfolio in direct lending because of that obsession with businesses.

• 39:25Ted Seides?

  What are some of the other micro cycles you're excited about?

• 39:28Speaker 00

  I mentioned telecom. Telecom continues to turn. AI has become important for fiber. You need to get the data back and forth, the fiber. And then it's become important in wireless, where spectrum is going to become more crucial. As we enter this inference phase makes me think of waiting for Godot again. Because in many ways, we're partially there while we're training, while we're doing other things. Fiber and wireless continue to be important assets. My partner Scott coined good terms for the highway and skyway of AI. That will continue to be important. Understanding how companies that their core business models might not be as interesting today, but they have an AI angle that's real. The other element I think is fascinating in telecom is fixed wireless has taken over as a very important part of the broadband ecosystem.

• 40:14Speaker 00

  It was 150% of the growth last year in broadband across the country. It's basically using excess capacity in wireless spectrum that T-Mobile or AT&T have to provide a broadband solution in the household. But it uses a lot more data than the wireless we're just going around in our phones. It's upended once again, the telecom ecosystem, which historically all you had was a cable company for fast internet. And now in some markets, it's cable plus fiber. And now it's cable plus fiber. Plus maybe Starlink, plus fixed wireless. This is an industry that was rewarded with tons of debt because it's supposed to be super stable. You're supposed to be able to just raise price every single quarter. No matter what you do, you call up and you beg, it doesn't matter.

• 40:56Speaker 00

  What we think is going to happen in telecom is more and more legacy, perhaps coaxial companies are going to be impacted by not only fixed wireless share, but fiber as it gets laid all over the country. And that fixed wireless is like a transitionary technology that eventually the large carriers will want to move those new subscribers to fiber that they've put all over the country and free up spectrum for AI and other things. We think we get another bite at the telecom microcycle as this transition happens away from legacy ways to connect to fixed wireless and to fiber. There's many companies that are in the crosshairs. I think about things that aren't, that are developing now. Software is obviously, everyone's talking about it's doomed, but it hasn't developed yet. Places that we're looking at are chemicals.

• 41:40Speaker 00

  We take seriously the Chinese five-year plans. It seems very clear to us that China is focused on reducing the cost of base chemicals, ethylene and propylene. If you look at the amount of ethylene and propylene that they're bringing on and then go to 2030 and shut all of the European and Japanese capacity, in 2030, you'd have more overcapacity than you have now. On top of that, China is moving up the tech stack. So in chemicals, the holy grail is, are you a specialty chemical or not? And if you're a specialty chemical, you have a high margin, high multiple, and you're great. If you're base chemical, you're more cyclical. China's going up the tech stack. All of us have to take Chinese technology more seriously everywhere. I went to China in 2009 on an autos trip.

• 42:26Speaker 00

  I was an autos analyst. We went around to all the auto plants. And in almost all the auto plants, we saw Usually a Toyota Camry, sometimes it was a Honda Accord that was being stripped down to literally copy what it was being done. That colored my view on how to think about Chinese technology in autos. Fast forward to today, Chinese EVs, and you're saying, I thought we were talking about chemicals, right? But Chinese EVs are not only competing on cost, they're better. They're really good. People want them. They'd be all over the US if we weren't having geopolitical reasons not to allow them in. Just go to Europe, go to the Middle East. People are paying for them. This is the first instance where China is taking share, not just on cost, that they're

• 43:10Speaker 00

  taking share on cost and quality, technological know-how. They're quickly moving up the chain in chemicals. They want to be making specialty chemicals. They think they're going to have an advantage because they've also will obliterate margins in base chemicals. We don't think the chemicals industry is ready for it. There's going to be enormous upheaval in the global chemical market, even starting this year. We'll be really interested in playing that microcycle as it goes through.

• 43:34Ted Seides?

  What you describe in chemicals sounds like a short opportunity. I'm curious how you put that into the context of your portfolio.

• 43:42Speaker 00

  My father was an equity research analyst for many years, and I told him what I was going to do. I was going to go to the buy side and work at a hedge fund. This was a long time ago. He said, the buy side? Who goes to the buy side? Right? He was shocked. Then he said, shorting is un-American. People don't like talking about shorting because in general, you want to be an optimist and you want to bet on things succeeding. But we do short. We short companies that are either frauds, that we think are frauds, although I will say we call nine out of every two frauds. What we look in a portfolio is a company about to have a microcycle or less, right? That the way they make money, again, if you are obsessed with business quality and your

• 44:26Speaker 00

  analysts can say, how does this company make money? The second they see holes in that, then they're saying, wow, this is a problem. Is it changing? So we short companies that have very overlevered balance sheets or are overlevered relative to how they might perform. It tends not to be, oh, they're going to miss earnings by a penny. It's more like, are there fundamental changes? We tend to be positive on certain industries and negative on other industries. We don't try and match, or we're not trying to be beta neutral or anything along those lines. What we're trying to do is find winners and losers as this kind of crazy global economy turns. In our hedge fund, shorting is a big part of what we do, but it's not a part of what we do in the other things. It informs it.

• 45:10Speaker 00

  Companies that were short, industries that were short, we don't touch them in direct lending. We don't touch them in the CLO. We run this business that's totally integrated, where Scott and I sit in the middle of it. There are no walls and there are many firms that have all these products, but not integrated in the way that everyone is talking to each other all the time. We have a Zoom that's open 24/7 and we're popping in and out of it. It helps us have better risk management and hopefully better investments across everything we do. So the shorting is important, but I would never want to contradict my father. It's bad enough I went into the buy side.

• 45:46Ted Seides?

  You mentioned healthcare earlier, the healthcare microcycle. Where are you playing that?

• 45:49Speaker 00

  Healthcare is supposed to be stable. We know all about the aging of the population that impacts the economy. We know the demographic data. We know how regularly everyone gets the flu. But there's enormous policy volatility in healthcare. We have decided in the United States that every four to eight years, we want to take a 180-degree turn in our policies in terms of who runs the country and what they support, which is crazy if you think about the long-term history. That impacts healthcare almost like no other. Healthcare, because it's predictable historically, is a place with a lot of, whether it's healthcare services, hospitals, rollups. These rollups create enormous value for doctors and for sponsors and for others, but they've

• 46:32Speaker 00

  run into a problem because if inflation was high in labor in healthcare. And so if I take the fact that I had labor and healthcare go crazy because they had a labor problem before the rest of the country had a labor problem, and I take the fact that every four to eight years, we change what administration priorities are. Medicare Advantage is great. Now Medicare Advantage is terrible. We want to get rid of Medicaid payments. We want to increase Medicaid. It's become a consistent opportunity to find businesses that should exist, need to exist, that aren't frauds, although you see them in healthcare more than other places. It's been an opportunity for us. It's hard because you have to realize that we could be investing on the back of policy volatility and then get impacted by that same policy volatility. And so we tend to stay away from things that are single product

• 47:17Speaker 00

  or single payer. We like it if there's a mix of commercial Medicare and Medicaid. We like larger businesses. We like return on capital. I once looked at a business in radiation oncology. The analysts are trying to think about what is going to be the government's payment for this product. I said, "The government wants radiation oncology, but thinks it's being overused. If you're sitting in a government office and you are being reasonable, what is actually the return on capital that would make sense for them to provide?" It was much lower than they were being paid. We look for businesses where we think not only is the current administration liking those elements of where they are, but what they earn today doesn't seem silly to us. It seems like a normal return on capital that would be supported

• 47:59Speaker 00

  by anybody. That's what we find. What the challenge in America for healthcare now is that healthcare costs are really rising again after a period of being less aggressive. If you think about elections, healthcare was the most important thing that we talked about in elections in 2000, 2004, 2008, and it really disappeared from our election rhetoric. Last year, you saw healthcare costs up across the board, commercial healthcare costs up seven and a half percent, employer payment for healthcare up 7%. The theme that could happen this year or the coming years is you see more people and more employers pushing that down onto employees, but in places where the cost is just getting out of hand.

• 48:42Speaker 00

  And the first place you're seeing it is with the ACA subsidies, the big debate over will they be extended. We're talking in late January, they haven't been extended, and that means that more Americans are going to be out of pocket for healthcare. Then, if employers start saying to employees, "You need to pay for parts of this," is inflation in healthcare going to suddenly impact how Americans spend for the first time in a while? It matters. There's a great study that Australia, their Medicare system, which is universal healthcare, they did an experiment where they said, if people just have to pay $1 or $2 for prescriptions, what does it do to utilization? It really impacted demand. We think you could start seeing inflation impact consumer choices in healthcare for the first time in a while. And there's not every business model set up for that.

• 49:27Ted Seides?

  Within all of the microcycle investing, there's been lots of change over time in how creditors participate relative to other creditors or the company, ZLMEs and other stuff. Where are we today in how you're assessing the landscape of other players in any of the credits you're underwriting?

• 49:49Speaker 00

  I joke, you can't have credit conference without a panel on creditor violence, which is exciting because people like UFC, and this is credit nerds trying to pretend that they're warriors, myself very much included. There are norms and there are laws. Norms evolve faster than laws evolve, faster than capital structures evolve, I have found. One thing to understand is, and I was trained as a lawyer, in equities, there are fiduciary duties to minorities. You could own 51%, you can own 80%, you can even own 40%. If you really screw the little guy, you have violated fiduciary duties to them, and you can be held liable for that.

• 50:31Speaker 00

  In credit, that doesn't really exist. The way the law has worked is, it's a contract. It's not being analyzed under fiduciary duties law. It's not being analyzed under what the securities laws say about fiduciary duties. It's contract. What does the contract let you do? Okay? There were norms that existed for a long time not to take advantage of those things. What's interesting is creditors, we've long been willing to beat the living daylights out of each other. It's a part of finance that isn't necessarily the most glamorous, and fighting is part of it. The norms held it together in the sense that there was just so much you could do. People wouldn't be willing to use loopholes in documents that were clearly there, but were designed for a different purpose.

• 51:15Speaker 00

  Those norms have really disappeared for good reason. Not only does capitalism require it to some degree, but I think also that a lot of levered deals got into trouble over the last few years, not because the owner, the sponsor, whoever it was, made a terrible underwriting mistake. That's usually what happened. It's because inflation came in a way that wasn't expecting. If you think about what corporates have gone through in the last few years, one of our themes is the resiliency of the economy. In the financial crisis, auto companies went from selling 16 million cars to 15 million cars. They were all immediately insolvent. Today, we had a pandemic that shut all production of everything. Then you went into inflation. You got the war in Ukraine. The Suez Canal is basically closed.

• 52:00Speaker 00

  And companies run from one thing to the next. They're resilient and they can handle it. Owners of companies said, look, inflation was worse than we thought. We don't want to lose the business over that. What basket can we use? There's been an approach to allowing creditors to fight more naturally with each other. That's happened over the last few years. It's gotten a lot of headlines. It's made it harder to invest in distressed businesses. Because what we do is we say, this business was once great. We think it could come back to being maybe good. Where should we buy the debt if it was worth a billion once? And if we can buy the debt for 500 million, do we think it's definitely worth 500 million? You might say, yes. But if you say, aha, you may think it's worth 500, but it could be that when you buy the debt,

• 52:44Speaker 00

  in reality, there's 750 that's going to go ahead of you. Really, you're buying it more expensive than it was before the world changed. I don't want to invest in that at all. So it's made it much harder to invest. I think everyone's acting rationally and responsibly. The world is turning. And one thing you're seeing is co-ops, which are cooperative agreements between creditors, to say, we're not going to do a deal with the company alone. Neither should you. Have really come into vogue over the last 18 months. There's fighting back against that now. There's publicized litigation against it. I think it's just a living organism. What cooperatives allow you to do is say to the company, we as creditors will give you a capital solution, not one in Individual creditor to screw other creditors. You're seeing that now in bigger situations.

• 53:29Speaker 00

  Smaller situations remain an enormous Wild West. Eighteen months ago, I was pretty down on distressed in the sense that I thought it would get worse and worse than your ability to invest. As the world turns and cooperative agreements and finding sponsors that are amazing to work with, that love their businesses, want to keep them and want to find like capital solutions for it. I'm more optimistic that it's not going to be bloodying each other, but it's investing.

• 53:55Ted Seides?

  How has the size and scale that you've created impacted your ability to influence a cooperative agreement or a situation where there's other creditors coming at you?

• 54:08Speaker 00

  We are very active in stressed and distressed. For better or for worse, sometimes it works really well, sometimes it doesn't. What that creates is a repeat player dynamic, where I don't think there have been many firms on more ad hoc committees around potential restructurings in court or out of court than us. There have not been more firms involved in more par syndicated loans than us from hedge fund side. I think there is a repeat player perspective that if someone is going to really screw diameter, I'd like to hope that they don't want to do that because they think they'll be on the other side of us and we should have goodwill. We were in a situation two years ago over Christmas where, boy, did we get it wrong. We underwrote this thing in August and by December it was out of money.

• 54:54Speaker 00

  Really not our finest moment. And we're going to have to liquidate a company over the Christmas season, which is the worst possible thing you can do. There were two creditors in the stack who had over 50%, which by the way, was a mistake from us. Don't want to be in a situation where a very small number of creditors can get to voting thresholds. What company called and said, hey, you guys have 51%.

• 55:18Speaker 00

  Amend the doc to let yourself be senior to everybody else and give us the $250 million we need to fix the business. One of the people said, "Diameters in this, they're small. We want to call diameter. We want to get them involved." We ended up doing something different and we got a great M&A outcome and no one knows how terrible it could have been. That's really worth something to me. That was a firm that we do a lot of business with and we all know the ethos. We're not going to hurt ourselves in situations to bend over backwards to make sure nobody ever loses money. That's not our responsibility. But if you're a repeat player, then the market treats you differently than if you're a one-time player. What I've learned from restructurings now is you need to give everyone time to pound their chest.

• 55:58Speaker 00

  I remember the first restructuring I worked on in great detail, the Lear restructuring. It was so clear to me how it should go. I had my model. I had my spreadsheet. It was so clear to me. We sit in a room with bank debt lenders and the company and the revolver and the unsecured bonds and everyone's yelling at each other. I turned to my colleague at the time, Charles Tauber, who's now at PJT. He was older than me then and older than me now. I said, "This is crazy. Let's just tell them we're like the largest secure, the largest unsecured." And he said, "You need time to pound their chest. Everyone needs time to scream and yell and then we will get something together." To some degree, you want to allow that to happen.

• 56:43Speaker 00

  In distress, it's part of the process. Being a repeat player helps, but you have to make sure you're well positioned because at the end of the day, people will be economic animals.

• 56:53Ted Seides?

  One of the other big trends in the credit world is the growth of IG from insurance companies and the demand for that paper. I would love to get your perspective on what's happening there and how it may or may not impact you in what you see the credits you're looking at.

• 57:11Speaker 00

  We do a lot of IG. We are very involved in IG new issue and IG trading and IG investing. We never want to be a tourist in anything. IG is sometimes interesting for our hedge fund, sometimes less interesting. Unless we were native to it and had every day in that market, we would be a tourist and you never want to be a tourist. The best explanation I gave is I was once around COVID time, traveling internationally, seeing a client and they still required a COVID test. So the night before, we're like, "What are we going to do?" My colleague from IR, Ryan and I, we spent $450 each for a COVID test in the hotel. The next morning, we drive up to the client, negative free COVID test in the lobby. Tourist, IG is a very important part of what we do in structured credit and in corporate credit.

• 57:56Speaker 00

  What you're referring to is the explosion in IG type capital solutions really driven by insurance. And we're very active there, too. I would say the private IG market has been a great place to invest because we've been investing in companies of consequence with really good structures to earn a little more. The earning a little more is the answer. If you think about the insurance business or the annuities business, it's taken off over the last few years for good reason. As rates have been higher and as Americans have aged, annuity products make a lot of sense. An annuity is a long duration liability that you get premiums in for that you have to invest over time. The way you invest is highly regulated.

• 58:41Speaker 00

  You can't buy crazy products. You have to do it in a very conservative way. If you are an insurer like this, the holy grail to you is a non-risky asset, an IG or IG-like asset that yields a little bit more than what investment grade. Investment grade is very tight at the moment. You're able to say to the world, hey, I can take illiquidity. So I have many years. I can match my asset durations with my liabilities. And what has emerged is insurance solutions business that provides these type of assets to insurers that oftentimes will give 50, 75, 100, 200 basis points of extra spread. It's a great business. We are involved in it. We're doing a decent amount of asset-backed finance. We want to do more.

• 59:25Speaker 00

  It's a responsible way that Wall Street is providing solutions that work for people. But there is a danger to it you're alluding to, which is when you're creating lots of tranche structures, the thing that we all remember is during the financial crisis, when people wanted new AAA, so they took triple B RMBS, combined it into a structure to create a AAA CDO square that was entirely composed of something that ended up being worth nothing. Then your rating was a helmet in a skydiving accident. Like, it didn't really matter. The analogy we used in our last letter is the great Seinfeld episode with top of the muffin to you, which were two characters trying to create a store just to sell the top of the muffin. It didn't work because when you just baked the top of the muffin,

• 1:00:09Speaker 00

  it didn't taste like a popped off top of the muffin. It didn't have the structure and the texture. Then I think it was Elaine and Mr. Littman. They decided to bake the whole muffin, pop the top, and then they needed something to do with the stumps. The garbage dump wouldn't take it because it's food, not garbage. I think they donated it to a homeless shelter and the person running it came and screamed at them that it was inhumane to give this to the homeless. They want the tops too. They don't want the stumps. They ended up closing. It failed because they had nothing to do with the stumps. One thing we're seeing is we really love the IG market. We love creating these assets for insurers, investing in them when they make sense for our funds. But some insurance solutions involve creating a muffin top and a stump.

• 1:00:53Speaker 00

  Because if you create a muffin top, you are creating structural seniority that makes for less risk. Makes a lot of sense and the insurer's balance sheet makes a lot of sense. What do you do with the stump? We've spent a lot of time trying to look at the stumps. The stumps often are residuals that don't generate any cash in the near term, but offer a nice kind of mid-teens return. We think that Wall Street is getting a little short on places to stick the stumps. They're coming up in special situations funds. They're coming up in interval funds. They're coming up in places that people may not appreciate what happens when you're not getting cash for a long period of time. This is technical, but CLO equity, which is a highly levered asset, is an amazing asset class.

• 1:01:34Speaker 00

  Because when anyone models a CLO, they say there will be a recession sometime in the next 18 months. I had an old boss who told me that if anything is coming in 18 months or the back half of the year, it means no one has any clue. But you model a recession every 18 months. What happens then with CLOs? You might get that recession to end all recessions and that will be bad for the assets, the levered loans. But you take cash off the table right away if you were the equity. That helps pay down your basis right away. While we love this IG-like Insurance solutions market, we're worried about the stumps and where they're going. If you're going to invest in ABF, you need to invest in people who are underwriting the whole thing correctly, who are thinking about, do we want stumps? If we want stumps, how are we underwriting them? And do we have enough milk to get them down, so to speak?

• 1:02:19Ted Seides?

  If that risk identifying were to play out, what might that look like in that ecosystem?

• 1:02:24Speaker 00

  I don't know. I do think that ABF has grown dramatically. I do think that the assets are demanded by insurers and others. If you could not create structured products out of asset-backed loans, we should have said asset-backed loans is everything from a loan on airline parts, a loan on a plane, a loan on an engine, consumer loans from companies like Affirm, Pagaya, to we even looked at a deal where it was buy now, pay later for Botox, which was an excellent transaction because people want to keep getting Botox and they tend to be high-quality borrowers. All of those things. If that engine slowed, it would make it harder for insurance to have attractive assets and to earn the yields that they've been doing. I don't think that it would create systemic problems, just like every hedge fund in

• 1:03:09Speaker 00

  the world wants to call a recession constantly because they're desperate for the volatility. Everyone wants to constantly say, what's the next systemic thing? Because the impact of being asleep in 08 and not appreciating that while subprime was small on its face, it had turned itself into every crevice of banks and therefore was a much more systemic problem. The impact of getting that wrong was so enormous that we all think about what are systematic problems. Here, the systematic problem would be that you'd have really bad returns in your interval fund. You'd have really bad returns in your special situations funds, not that the global economy comes down.

• 1:03:46Ted Seides?

  As you think about the systemic risks alongside of your identification and diving into microcycles.

• 1:03:55Ted Seides?

  I'm curious how you incorporate what matters in a macro landscape into what you're doing.

• 1:04:01Speaker 00

  We're obsessed with macro. We think you can't outsource your macro. The team has to be on the same macro footing. If someone comes and says, I want to make an investment in a retailer or building products company or an industrial company. The first question is, what GDP assumption are we using? What inflation assumption are we using? Are we making a economy bet, a market share bet? We're not economists, but during COVID, we were pretending to be epidemiologists. It wasn't that we were saying, oh, wow, this is going to happen. It was, hey, we need to understand ourselves, what the outlines of the potential spread could be. Every single morning I would wake up, analyze the data on COVID and send a note to the whole team. That turned into kind of my pet COVID blog project.

• 1:04:44Speaker 00

  We do the same with macro. Scott and I really believe in making the sausage. Scott does an enormous number of our traits. I do our macro. When CPI comes out, when the jobs report comes out, I go into it. I have my own models. I create my own charts and most of the charts I create don't show me something. And so integrating that and constantly being in the numbers, in the data. I don't want to be someone who's receiving a PDF or a deck and just reading it. I want to see how it's made, how it goes through. Understanding it has allowed us to have theories on the economy. We think that the consumer being under levered has been part of an income cycle. Higher wages, higher spending, higher inflation that will of course one day break, but doesn't abruptly stop.

• 1:05:27Speaker 00

  It doesn't just stop immediately because it doesn't have a lot of debt and because wages have been growing. Therefore, we can see through these scares when everyone screams recession from the rooftops every six months. Because consumer spending dipped a little that month. We incorporate it in everything we do. The analysts all incorporate it in their modeling and in their industries. They then give it back to us. This is what we're seeing. Last year, we saw packaging really get hit. What's interesting is packaging is an industry that's supposed to be super stable. And now it's widened significantly from the index to almost be stressed. We said, is this a slowdown in the consumer? One of our analysts thought it was. And we said, wait a minute. How is it that you can't get a concert ticket or an airline seat?

• 1:06:11Speaker 00

  Cruises are doing fine, but packaging is suffering. It made us realize that part of the elements of the, I guess, the K-shaped economy that people refer to, which I don't love as an analogy we're playing through, that packaging is one of the places that is even or more even across the economy. Whereas in places like durables and services, the top 25% are responsible for, say, 50% of the spending. But that also something else was going on, that it couldn't just be the economy that was explaining it, because you actually had an incredible GDP here for personal consumption. It's that GLP-1s were impacting grocery, that changes in alcohol were changing spirits buying. And that we think a mystery that's happening that really can't totally get my head around.

• 1:06:55Speaker 00

  And that's why we haven't made a lot of recent investments in packaging is, it seems that Americans are using less, right? Buying less food, even with not on GLP-1s. I have theories, maybe people were so oversupplied with this stuff after COVID and then those things got hit by inflation, that they're learning to use it less. So the macro informs everything we do and we don't make macro trades. It said it informs us, it gives us a big advantage over others that wait and see what the banks economists will say and then maybe or maybe not incorporates it. Also, our models have to be the same. If we have two different analysts with different macro inputs, one for autos and one for housing, then what are we doing in terms of thinking about what's better, housing or autos? Well, something Scott and I take seriously and that we also enjoy.

• 1:07:38Ted Seides?

  How do you think about your positioning in a world where there's this surge of very large credit players? And you have scale and there's another side that's probably much too small to compete in this world.

• 1:07:54Speaker 00

  We manage upwards of 25 billion. I was at a credit conference for Apollo last year, and I think on the stage it said they managed 450 billion. Right? Our mothers are very proud of me and Scott and the whole team, but we're a pipsqueak compared to them. This question is overhyped because it's an important question as investors try to figure out, are you going to lose your edge? That's the hardest thing to do. Figure out if the past is going to be the future, whether it's a stock or a bond, or if a GP who's been good is going to continue to be good. For us, it's all about, do we have a flywheel that works? Even when we just had a hedge fund, we've always done two things. Try to find cheap bonds or loans or overvalued bonds and provided capital solutions.

• 1:08:40Speaker 00

  We originally did it through the syndicated market only. Now we do it through the direct lending market and capital solutions. And are you of a scale that you can continue to be relevant? And so direct lending, we didn't think we would have eight years ago when we started because it didn't complement the syndicated market. Today, it's crucial to have direct lending because sponsors and others want both. They want a syndicated solution, a direct solution. You have to be able to look at both. We don't do relative value, but when we're looking at something in direct lending and it's only, say, S plus 475, and there's something similar at S 400 in the syndicated market, we were saying, maybe you're not getting enough for the illiquidity.

• 1:09:23Speaker 00

  I don't think the absolute size matters. What matters is in the markets that you're in, are you relevant? One of our favorite examples was December 26th. And Scott was on the desk, got a call from a sponsor that said, we're trying to return money to our LPs this year. That's been a big theme in private equity. One situation that we were banking on is it didn't come through. There's another portfolio company that we would like to do a dividend for. We know that you guys own the syndicated debt in your CLOs and also own the bonds in your hedge fund. You must know this company very well. Would you do a juicy direct loan dividend deal between now and December 31st?

• 1:10:05Speaker 00

  Of course. That means there are many bigger hedge funds, there are bigger CLOs, there are bigger direct lending businesses. The question is, are you relevant to get the best deals that you want to put together your portfolios? And we are. The Supreme Court says pornography, you know it when you see it. That's also true with being too big. So we've purposely capped our funds. Our hedge fund has been hard closed, return capital on two occasions. We capped the size of our most recent dislocation fund because we don't want to be in the situation where we get too big and we can't actually invest. That's the constant trade off. I understand why the question is asked, but it's all about that relevancy flywheel in what you're doing as opposed to the absolute size.

• 1:10:47Ted Seides?

  Well, Tim, I want to make sure I get a chance to ask you a couple of fun closing questions. Before we get to the closing questions, I want to tell you about one of our strategic investments. We've made a few and each are working on a product or service we think will be valuable to our community. One is Ascension Data. Ascension provides workflow software for compensation that allows you to track, plan, and take care of your team. We're excited for you to check out how they can help solve the sticky pain point of compensation. There's a link in the show notes so you can learn more. And here are those closing questions. What is your favorite hobby or activity outside of work and family?

• 1:11:25Speaker 00

  The last time I was on, I had prepared the answer, and I think I talked about running, and I've thought about it since. I wish I could tell you that I have this great hobby where I build ships in glass bottles, or I whittle wood. But the truth of the matter is... I don't really have hobbies in the sense of really perfecting something to be good at it outside of work. I like to ski. I like to run. I like to read. I don't have hobbies in this traditional way because I do what I like and it makes me boring, but I like reading about the news and reading about the world. So I regret going with running last time and I hope I have righted the record that I am the hobbyless man.

• 1:12:11Ted Seides?

  What was your first paid job and what did you learn from it?

• 1:12:15Speaker 00

  The first real job I had was the summer after senior year of high school. I got hired to work at the New York City Economic Development Corporation as an intern. We were working on bringing jobs to Silicon Alley in New York. This was the summer of 1997. I learned an enormous amount, but I also learned about the impact of office politics. This is a political place, political job, and boy, was it political. Everybody trying to figure out where they stood, who gets invited to which meeting and when and what your seniority level is and it's government. So who gets a driver and who doesn't? I think that politics kills organizations. I love politics, right? I'm obsessed with politics, but office politics is deadly. I remember when I

• 1:13:00Speaker 00

  was at my last firm, once I knew I was leaving at the end of my time there and I just focused on investing. I was never a better investor. It wasn't like, who's in that meeting? Who's going in here? Do they have more points than me? Are they getting this? I just invested. It did great. We've gone crazy at Diameter to have as little politics as we possibly can have. It's a very flat organization. It violates a lot of the rules you learn if you buy management books in the airport. We're very transparent. I credit Scott for really teaching me that. The first place I saw how just pernicious office politics are were what was an amazing job. I loved A D C, but that's what I learned from it.

• 1:13:40Ted Seides?

  What's your biggest pet peeve?

• 1:13:42Speaker 00

  We spend a lot of time on Zooms at Diameter, both internally and externally. I don't see why the norm has become that turning on your screen is optional. The whole purpose of the Zoom is that we can have a more intimate discussion, looking at each other and seeing facial expressions than we can over the phone. At diameter, we have a rule that your video has to be on at all times. We do it externally also. It's a real pet peeve when people are sitting in an office with the screen off. We know that you can be looking at the screen and not focused on your work, but at least creating that illusion makes for better calls. So the screen off in Zoom is my pet peeve.

• 1:14:23Ted Seides?

  What's a mystery you wonder about?

• 1:14:24Speaker 00

  I think the next two years are giving us so many known unknowns that I can't really wrap my head around it. Today, just sitting here with AI, not even really ready for primetime, and you have very high, I think almost 9% unemployment from college grads. What's going to happen if that goes to 20%? We're going to have an election, maybe, as that is coming around primetime. Figuring out what's fake or not is impossible. The mystery to me is we've had this great experiment with representative democracy, where we send people on and most of us then just do work. For two years or four years, we lift our heads up, we say, hey, were you good, were you bad? Vote you in, vote you out.

• 1:15:08Speaker 00

  Representative democracy really only works if you have accountability. Say, hey, this person was terrible. And you pull them back. When Jimmy Carter was voted out of office after 2008, the Iraq War, the American people said, no, this is not working. You can't have accountability without some shared set of facts. Half the country thinks that the January 6 people were traitors. Half the country thinks they were patriots. The mystery to me is how our system is going to see through this. Forget about any particular politician. The mystery is the system working with AI. Like, how did it work retraining all the steelworkers for internet technology jobs? It failed because it's impossible in a democracy. You can't say, quit your job now, we're going to teach you something else to be an internet salesperson.

• 1:15:53Speaker 00

  Doesn't work. Transitions, when we're already in this period of nothing is real and everything is fake, is a mystery that I am not certain we'll be able to see through, as optimistic as I would like to be. I've made a life and a career out of being an optimistic person.

• 1:16:05Ted Seides?

  All right, John, last one. If the next five years are a chapter in your life, what's that chapter about?

• 1:16:10Speaker 00

  Scott and I still think of ourselves as very young. This is the part of the year that we're the exact same age or both 46. The question feels alarming to me. I was talking to someone who was president of an old homeowners association. And I said to her, what's your goals in your presidency? She said, keep everything the same. We don't have that luxury, though. And what's really important to me and to Scott is to be able to make the sausage. And the technology is changing so quickly that you have to stay on top of things. What worries me and what I'm focused on, what I see the next five years being for me personally and for Diameter is all of us learning how to use this technology, not being left behind by this technology.

• 1:16:52Speaker 00

  If they outsource the managing partner of an investment firm, I'm screwed because I want to do this for a long time. And so, learning the skills to continue to compete at this level five years from now is what this is about. This is an epic of extraordinary technological change. I hope we can wake up in five years and I can say, and Scott can say, and our team can say, we are at the forefront of using this technology to produce alpha for LPs. We'll see, but that's what I hope the five years are about.

• 1:17:22Ted Seides?

  John, this is so much fun. Let's make sure it's not another five years before we do this again.

• 1:17:27Speaker 00

  Thank you for this opportunity. You have an incredible network here. What I think is cool is I listen to this podcast all the time, so I will have to skip the episode where I'm in. It's humbling to be on with so many of the great investors and allocators and others that you've had on. Thank you.

• 1:17:41Ted 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.

• 1:17:57Speaker 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.