Kieran Goodwin – Private Credit Concerns (EP.494)

Kieran Goodwin is a Partner at Saba Capital, a $6 billion hedge fund manager that seeks to identify dislocations in credit and equity markets to generate convex returns in volatile times. Kieran has been one of the top credit traders on the Street for the last three decades across roles at investment banks in the '90s and early 00's, King Street, his own hedge fund, Panning Capital, and most recently, Saba that he joined in 2024. Our conversation covers a tour of Kieran's background, including early experience with credit derivatives, growth at King Street, lifespan of Panning, downtime between stints, and re-engagement with Boaz Weinstein at Saba. We then turn to risks in the private credit market, including its rapid growth, asset-liability mismatches, pricing marks, leverage, liquidity, default risk, and the potential for reflexive problems. Kieran shares how managers should navigate the environment and how he is positioning Saba to benefit. Learn more about our Strategic Investments: Thema https://www.thema.ai/ted. 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've looked throughout my career for asset liability mismatches and I truly believe that asset liability mismatches cause liquidity crunches and liquidity crunches can cause credit crunches. Credit is correlated when it gets stressed. The bear case, which I'm not saying it's going to happen, but what happens is you get redemptions, you get some real defaults, you get for selling of private credit. And in the interval funds, you just run out of what's liquid and the bar to gate is really high. That goes on a feedback loop of where's the actual bid for private credit? It's hard to say.

• 0:46Ted Seides?

  I'm Ted Seides and this is Capital Allocators. My guest on today's show is Kieran Goodwin, partner at Saba Capital, a $6 billion hedge fund manager that seeks to identify dislocations in credit and equity markets to generate convex returns in volatile times. Kieran has been one of the top credit traders on the street for the last three decades, across roles in investment banks in the 90s and early 2000s, King Street, his own hedge fund, Panning Capital, and most recently Saba that he joined in 2024. Our conversation covers a tour of Kieran's background, including early experience with credit derivatives,

• 1:29Ted Seides?

  growth at King Street, lifespan of Panning, downtime between stints, and reengagement with Boaz Weinstein at Saba. We then turn to risks in the private credit market, including its rapid growth, asset liability mismatches, pricing marks, leverage, liquidity, default risk, and the potential for reflexive problems. Kieran shares how managers should navigate the environment and how he's positioning Saba to benefit.

• 2:00Ted Seides?

  Before we get going, after a long winter, we're starting to see green shoots in the changing of the season. Spring training for baseball, March Madness for basketball, and the Sunshine Double in tennis all remind us that hope springs eternal. But these days, it's harder to be optimistic about another list of challenges. Private market liquidity, peace around the world, and keeping up with my son Eric in creating witty Spread the Word clips. Now, I can't figure out what will happen in private credit, how the private equity bottleneck will ease, what benchmarks should replace the S&P 500, or why so many people have reached out commenting on Eric's lack of interest in the show.

• 2:44Ted Seides?

  But I do know that the answers await from our incredible guests, and you should encourage all your colleagues to listen in and find out that truth. Thanks so much for spreading the word. 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 SuperAnalyst, an always-on agent that works like a power user on your behalf. It draws on over 500 million premium sources,

• 3:27Ted Seides?

  including broker research, expert transcripts, company filings, and earnings calls, and keeps working long after you've gone home for the day. Point SuperAnalyst at a theme, company, or market, and it learns the coverage universe so you can easily turn new insights into the briefs, models, and memos you'd otherwise build by hand. It was designed to work like an extension of your team, so it remembers your projects, follows your templates and processes, and links every output to its source so you can see where each conclusion came from. 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.

• 4:09Ted Seides?

  Start a free trial at alphasense.com/capital and see what it has ready for you. Capital Allocators is also brought to you by Bridgeline, 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. RidgeLine is built to change that line's trajectory, to be the inflection point that takes your growth from incremental to accelerated, with the team you already have in place.

• 4:55Ted Seides?

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• 5:38Ted Seides?

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

• 6:22Ted Seides?

  Karen, thanks for doing this.

• 6:24Speaker 00

  Happy to be here, Ted. Great to see you.

• 6:26Ted Seides?

  Why don't you take me back to what led you into finance in the first place?

• 6:30Speaker 00

  I was a computer science major at Duke my junior year. A good friend of mine gave me a book. He said, I think you'll like this. And it was Liar's Poker. I read it in one night. Literally, it was a party that night. I stayed in my room, read the book in one sitting. I know Michael Lewis thought it was a way to dissuade people, but I took it the other way. I liked math. I liked puzzles. I liked risk, in a sense. Learned how to play poker with my grandparents when I was young. I hadn't really been much exposed to the markets, but after reading that book, I was like, this is something that fits me.

• 7:03Ted Seides?

  And what was your experience like on the street?

• 7:05Speaker 00

  Another buddy from Duke's dad was looking for an analyst at Smith Barney. My friend recommended me. I had had a job in consulting at Anderson Consulting, which became Accenture, like a computer science programming job. Interviewed there, which was fortunate. Did that for a year as an analyst, then became a sales trader at Smith Barney. With my math background, tried to get into equity derivatives. There was no seats. I got into interest rate derivatives at Smith Barney, which great first four years, then left there in 1995 to go with a senior trader who was an interest rate derivative trader to Citibank to become a credit derivative trader, which I actually didn't even know what that meant, but I trusted the guy and left with him.

• 7:45Ted Seides?

  What did you see in the differences across banks in your time on the street?

• 7:50Speaker 00

  When you're talking 25 years ago, culturally, the places were much different. Smith Barney, for example, was Italian and Irish Catholic. Morgan Stanley was more WASP-y. Then I moved to Citibank, which were strong derivatives, really international mix, which was unique at the time. Then I went to Merrill, which was like Mother Merrill. Many people got jobs on the street because they had a relative that was doing it or they grew up in the tri-state area or had some connection. It was much different than now.

• 8:20Ted Seides?

  What led you to go from that initial step from one bank to another bank during your time there?

• 8:25Speaker 00

  I got enamored with this idea of derivatives and options and swaps, thinking about edge in the form of knowing the bond math better, in a sense. Starting interest rate derivatives, credit derivatives seemed like a green field and I was pretty young at the time. Citibank, they had a strong derivative culture, but really weren't talking to investors. So I figured out I needed to make a move, if I was doing credit derivatives, to a place that actually traded credit. I went to Solomon Brothers, which was a great experience. That was the beginning of real credit derivatives with the Asian contagion of 97. Then I had an opportunity to join Merrill, which I'd interviewed prior. I had a bunch of friends there that I wanted to work with, that I thought were talented people, moved there

• 9:07Speaker 00

  in 98, trying to optimize, maximize my quest to make credit derivatives a real thing.

• 9:14Ted Seides?

  When you first moved to the buy side, what did you think you knew that you didn't, going from prop to hedge fund?

• 9:23Speaker 00

  It's funny, I remember there was this client at Citadel, Dave Snyderman, who's now the head of Magnitour. He gave me some insight. He's like, when you're on the sell side, you buy on the bid and sell on the offer. That's what you're trying to do. And then when you go to the buy side and you initiate a trade, you're automatically down because you're paying bid offer. And especially in credit derivatives, corporate bonds at the time, the bid offers were real. But I was like, wow, you have to be much more intentional. You have to come into the day with a plan. I feel like I had a plan on the sell side, but I was also reacting to flow and reacted to clients. The strategy of thinking about how you want to create a portfolio, trading positions, also exit strategy, all of that

• 10:08Speaker 00

  hits you in the face when you go to the buy side.

• 10:11Ted Seides?

  What was your time at King Street like?

• 10:12Speaker 00

  It was awesome. It was a blur, in a sense. I'd met a friend, Brian Higgins, in the late 90s. When I was at Merrill, a friend of mine who was a salesperson knew them, and we pitched them the idea of credit derivatives as a way to go short because they had been short in high yield bonds. This was a more efficient way to go short, non-recourse, in a sense. We had a great relationship there. I talked to them when I was going to the buy side. They weren't ready. I went, traded prop for a couple of years. Then I was getting recruited as Fran for a reference. He was like, why don't you come here? At the time, I understood the credit markets. I understood derivatives and how credit derivatives fit in and the relationship between bonds and credit as a basis.

• 10:54Speaker 00

  I wanted to go deeper into distressed investing, thinking about value. It was magical in the sense Fran was this amazing distressed investor, a great analyst. I had this other skillset, which not a lot of buy sides had. So the combination was so much synergy, coupled with amazing amount of volatility in the markets. Starting in 05 with some mini default cycle, then LBOs and then subprime and into GFC.

• 11:23Ted Seides?

  What'd you learn about navigating all those choppy times?

• 11:26Speaker 00

  Learning options. I remember when I became an interest rate trader, I got the John Hall book about option theory and went through it. And it's probably some of the deepest studying I ever did. I was always more comfortable being long options and short options. The goal was, how do you find the cheapest options with the lowest amount of theta in the markets? Meeting someone like Fran, who intuitively understood options from a distressed investor standpoint. That was eye opening. We were always long options in the sense that we were buying either distressed debt or we were shorting credit. We embraced the volatility and probably did our best during times of volatility. When markets are calm, I'm not that good.

• 12:12Ted Seides?

  You started early on in credit derivatives, bringing that over to the buy side as a short mechanism, distressed when it was still a cottage industry. How did you think about navigating the changes in the credit markets over the years of your career?

• 12:27Speaker 00

  I was learning from the ground up, coming over there and there were still remnants of Enron's, which was a great case study to understand how you have this going through Chapter 11, which for Enron was pretty much a liquidation. Creditors at the same time was developing complexity as far as all the tranches of indices that were trading in synthetic CDOs and correlation trading. That was all happening. I looked at what Fran and Brian were comfortable as investors. How does that translate into what I know? For instance, in late '05, we had this many default cycle in auto parts and airlines. There were all these correlation trades that blew up such that when you were tranching portfolio credit synthetically via CDS, the equity tranches got really cheap.

• 13:12Speaker 00

  It reminds me today where you just had one or two sectors having a lot of stress like we have today in the SaaS with respect to levered loans. And we're seeing it in CLO equity has way underperformed the relative loan market because all of the damage has been in one sector. It was the first loss, the equity piece, you're getting the brunt of that.

• 13:33Ted Seides?

  What did you see differently as a trader working with fundamental investors?

• 13:40Speaker 00

  When I was a sell side or trading prop for a couple of years, my timeframe was a few months, maybe six months. When you're doing value investing, whether it's distressed or stressed, Lehman position, for instance, many of these distressed firms had for 10 years. It's a book, which the chapters, you don't know what's going to happen and pivot. You have basic ideas of where you think value is, but that can change and trying to always be curious on a situation for years at a time. It takes a level of concentration that me as a trader didn't come naturally to.

• 14:13Ted Seides?

  Over your time at King Street, how did you think about your own career when you went to leave?

• 14:20Speaker 00

  I left in early 10, 2007, 2008, 2009. We were in the thick of it. It was exhilarating and satisfying, worked with amazing people, but it was draining. I had young kids at the time. We had done as a firm way better than I thought. We started, when I got there at $4 billion, we're up to $22 billion. For the six years I was there, the S and P was flat and we were up over 100%. And then personally, I did a lot better. I needed a reset. I wasn't thinking about what was next as much as I just know that right now I need to pause.

• 14:53Ted Seides?

  So what'd you do?

• 14:54Speaker 00

  For two years, I failed to reinvent myself many times. I went to work for Mayor Bloomberg as an unpaid consultant. I think I lasted three months. Then I went back to school to get a master's education. It lasted four months. The pace of play was way too slow. I bought a farm upstate. I worked with a farmer on some greenhouses. Nothing took. Then a great friend of mine, Frank Edmonds, who was at King Street, was leaving King Street. I was like, what are you going to do? And he's like, I'm hoping to start a hedge fund. I'm like, oh, that's interesting. With whom? And he was like, my goal was to convince you. That was the perfect partner for me. Frank was lead analyst, head of research at King Street, trained a bunch of analysts.

• 15:37Speaker 00

  We were complimentary in the sense that he was more calm and collected than I was. And southern gentleman. I was like, well, if I'm ever going to have a chance to start a hedge fund, this would be an ideal partner on so many levels.

• 15:51Ted Seides?

  Take me through that journey.

• 15:53Speaker 00

  Frank ended up staying at King Street for another year. I started panning on my own. It was fun in the sense that the day I left King Street, there were five different LPs that reached out to me. Most called me. It seems foreign now that no one calls each other. At first, we're like, thank you for your efforts. You really helped King Street do well for us as an LP, which was gratifying. If you ever want to start something, we'd love to talk to you. I dismissed it, but remembered who those people were. I think four of them invested on day one out of 10 investors, which is great. You have that confidence is amazing. Even with that, you do 100 meetings, you get 10 investors. It's hard. Starting a hedge fund is difficult.

• 16:36Speaker 00

  Anyone who does it successfully, I always have a hat tip to because you're out on your own and it's easy for people to say no.

• 16:44Ted Seides?

  How big was panning out of the box for the first couple of months?

• 16:47Speaker 00

  We launched with 600 million. We did really well. And one of the mistakes I made was we took in money too quickly. So we grew pretty fast. Had two and a half billion within 18 months or so.

• 17:01Ted Seides?

  What happened over the couple of years you were running?

• 17:04Speaker 00

  We ran it for six years. I personally made a lot of mistakes in running panning. One was not necessarily understanding that we were in this low of all regime and it wasn't really going to change. Getting the macro right sometimes even as a fundamental investor is crucial. That was a painful lesson to learn. But we started off so hot in 2013, we're up 20% net that it's also like, oh, wow, this is easy. That's the worst thing you can think about as an investor, I think. Every day you have to assume you start with zero next to your name. You're probably going to have some hurdle adversity to overcome. 2014, we're doing well. It got tougher. We were up one for that year.

• 17:49Speaker 00

  15 was a really hard year. We were down five, then up five or six in 16. I just got tired of it, to be honest. I had too mature of a team. I was better as a manager, training younger people. That was my experience at King Street. I learned that in real time. I had a talented team, but it didn't fit the way that I operated the best.

• 18:11Ted Seides?

  What were some of the other mistakes you made?

• 18:13Speaker 00

  Every manager at some level gets away from what they're good at. Sometimes that makes you uncomfortable and gives you bad risk positions. So you stretch on what your comfort level was. For instance, I was in the Fannie Freddie preferreds early. A good salesperson called me. He's like, this is a cheap option. This guy had a great nose. I was like, oh, that is, that does make a ton of sense. So we bought them at three and they were at 13. I remember thinking, wow, now this becomes a legal bet. The delta went from a five or 10 delta to a 40 delta. That's not my strong suit. Even if it's not mission drift, you just have to get out of trades. There were a bunch of trades that we went into.

• 18:56Speaker 00

  They were in my wheelhouse and then they did well and they got out of my wheelhouse. And some of them were really bad reversals.

• 19:02Ted Seides?

  So you go to step away the second time, probably knowing that the slow pace wasn't going to work for you. How did you spend those next couple of years?

• 19:11Speaker 00

  I left in 18. Then my kids were older. It was great to be with them. They were in high school or coming to high school and were super busy interacting with them and helping them navigate their days and assisting them. That was super rewarding. Going to see their event, helping them with homework, thinking about their college journey. I was definitely busy with that. I remember getting the advice when I left King Street, you should meet with as many people as you can. I was like, no, I want to try to help New York City. I want to try to be a teacher. This time I was more open. I would literally meet with anybody for coffee that was interesting during that time. I met you for the first time. I was more open minded about it and more relaxed about it. With maturity, you get some wisdom.

• 19:53Ted Seides?

  How'd you think at that time about what you wanted to do next?

• 19:57Speaker 00

  I was resigned to the fact that I probably wasn't going to be an investor again. I didn't think there would be a third act. It was somewhat by chance. I failed again trying to reinvent myself, but there were more fun failures. I took a standup comedy class and performed. When you do these classes, they intermix real comedians because otherwise it could suck for the audience to see a bunch of people that weren't really good. Through my kid's school, I became friendly with Jim Gaffigan. So I technically opened for Jim Gaffigan. I went on right after, or else I would have pursued that. COVID was literally the next day and I lost some momentum. I created a game on an app. That was a fun project. So I was not trying to necessarily save the world, but just pursue things that

• 20:41Speaker 00

  were fun for me. Then Boaz, who I've known since the late 90s, he reached out to me in 21. He was like, oh, I'm putting up a board for a proxy fight on a closed end fund that owns levered loans. Would you want to do it? I'm like, sure. I know a lot about levered loans. I've got time. I did that. A couple of years later, I was still on the board. He was like, hey, can you come in? I'm thinking about making a bid for Sculptor. They have a credit business that's long fundamental credit and you know more about that than I do. Would you help me? And I'm like, sure, I'll help you. We went through that process. I'd never been in a hostile takeover situation. The bidding group was super interesting people that he's friends with. That took six months and we didn't win. But that got me, maybe there is an itch to scratch.

• 21:24Speaker 00

  I honestly, before that hadn't thought about what could I do? We lost around Thanksgiving. After the Holly season, I went into Boaz in early 24. Hey, listen, that was cool. He's like, not for me because I spent a lot of legal money. But we made a lot of money for the shareholders of OXIF or Sculptor. I was like, I have a couple of ideas. Hire me as a consultant and I'll run these down. And if nothing comes of it, then we'll part ways. I was like, I want a wisdom role and I had these ideas. I didn't necessarily want to trade anything per se. So that's how I got to Saba.

• 22:00Ted Seides?

  Take me through the path of private credit from financial crisis, replacing banks to where we are today.

• 22:08Speaker 00

  From the financial crisis, the idea was banks aren't necessarily the best vehicle to make loans because they have deposit flight risk. Also, you had the six-time levered rule. I forget the name of the rule, the guideline. Banks, we don't really want you lending to six-time levered companies. Some companies that are six times levered, like a software company, could be a good credit risk. Private credit had been around. It's not like Gollub started Ares and even Silverpoint. There are a lot of people doing private credit, but this idea of, okay, let's do an institutional style, drawdown fund, the duration of that fund matches the assets. And we take away this asset liability mismatch. Everyone talks about direct lending.

• 22:52Speaker 00

  There's all kinds of private credit, but let's just talk about direct lending for now. That made total sense. But then you had this idea of we still can make more loans, but we're tapping out of demand here a bit. Maybe we do a non-traded BDC, which was now up to 2018. That's where I was like, well, this is the original asset liability mismatch that you tried to cure by doing a drawdown fund because you might have all the investors looking for the exit, even though it's definitely 100% on page one of any prospectus, or there's a gate, you're going to get 5% liquidity. It grew really fast. Zero $350 billion in non-traded BDCs from 2018 to now. That's unprecedented.

• 23:37Ted Seides?

  As you look at the rest of the interval fund structure and the growth of the wealth channel into this space, what are some of the strengths and weaknesses in the various differences between the original drawdown structures, you mentioned the non-traded BDCs, now the interval funds?

• 23:53Speaker 00

  The drawdown fund has got the best asset liability mismatch. I'm invested in a bunch of different kinds of drawdown funds, and they're ugly. You get capital calls, you get distributions, you're getting a lot of K1s. I'm in a good fund, started in 2012, still have a 10% position in it. They last a long time. They don't necessarily meet the demands of retail from that standpoint. Then you have the non-traded BDC, which I do think that there is a potential for a non-traded BDC to work with the right private wealth client. The marketing happened pretty fast and furious, and there might be a mismatch

• 24:37Speaker 00

  of the right client to the product. The level of sophistication of the private wealth channel is varied. I don't know if it's like, we're going to videotape you saying that you understand about gates. I don't know if that's the right thing or not. It's probably not. And interval funds, honestly, didn't know what an interval fund was until recently. It's a concept that's somewhat strange in the sense that it's less levered, so that makes sense. Then, how do you meet that demand? The bar, you can't really gate. You have to give the 5%. The 5% or so liquidity every quarter, that's a great feature. That has to be cash. As long as you have assets that you can turn to cash or you have lines. At the heart of any of these non-traded BDCs

• 25:22Speaker 00

  or interval funds, what's the risk management? How thoughtful was the risk management? Is this contemplated for assets going down? How long can you sustain outflows for? I started a hedge fund. You launch, you take in money. You're like, this is great. King Street was a wild ride. We were growing assets all the time. It's hard to think about the downside. What happens if we suck for a while? Then what? No one really wants to talk about that.

• 25:48Ted Seides?

  What would proper risk management look like in one of these products?

• 25:53Speaker 00

  Good risk management would be a bigger liquidity sleeve. So maybe more levered loan BSLs. Trying to minimize unfunded commitments would be good. Unfunded commitments, whether it's a delayed draw term loan or a revolver, no one wants those. There's a kind of a cost of doing business. That's why credit derivatives was started. Banks didn't want those on. Let's hedge them out. You're not getting paid as much. You have the same credit risk. That would be one. And then being transparent on what is in the portfolio. Apollo came out. We're going to mark every month. That's a good move. But having marks that are as accurate as possible, it's hard sometimes. I'm not saying that there isn't going to be variance amongst marks, especially on private credit. But really being good about marks,

• 26:38Speaker 00

  whoever explains their portfolio the best, does that mean one-pagers, which you get in an institutional fund? Or does that mean a teach-in? That's where I'd like to see it to go. Even though you're like, well, how is that risk management? The better that you inform your investors about your process and the investments that are in the vehicle, whatever the vehicle is, the more comfortable they get, the less they're going to rush to the door.

• 27:01Ted Seides?

  I'd love to walk through a couple of the issues that commonly come up. You mentioned two of them, leverage and marks. But why start with the marks in the private credit world? When you look at loans underneath one of these portfolios, where do you have concerns that the marks may not be accurate?

• 27:18Speaker 00

  There's some obvious ones where...

• 27:21Speaker 00

  You see, let's just say, public BDCs that own the same club deal, the same loan. One BDC versus another, or two or three versus a fourth BDC, there's a massive variance. In a second lien especially, where you're like, wait, the first lien we know is stressed a bit. So maybe it's worth 90 or 85, not that it's impaired, but we'll throw it out, a bad sector. It's a stressed SaaS loan and it has a second lien. The second lien's gotta be below 85. Then you have one where a bunch of guys are marking it 60 and then there's a fourth one marking 85. Come on, you can do better than that. Yeah, maybe if you marked it 70. So there's some wild variance, easy ones.

• 28:06Ted Seides?

  When you look at the volume of those situations where it's easy that there's a wild discrepancy, how does that roll up into whether that's a systemic problem in the space?

• 28:19Speaker 00

  If you rated the big non-traded or public BDC managers on a scale of one to 10, 10 is the best marker and 1 is the worst marker. What's the NAV difference? If the guy that's rated 10, he's at the top of the heap, his NAV is probably the most accurate snapshot for this. Obviously, there's delay here as well because they mark by quarter, which is Apollo trying to do. What is the guy that's rated 1? What's the difference in NAV? 4% or 5%, maybe 6%? It compounds a bit. Then you have micro situations where loans are getting marked from 100 to 0 in one quarter. Everyone goes to the worst because credit is about believing. You have to believe.

• 29:04Speaker 00

  Kredir is credit means to believe. And when you lose belief, it happens really quickly. Trust is the biggest thing.

• 29:11Ted Seides?

  Recently, there've been this wave of redemption requests above that 5% threshold in the non-traded BDCs and interval funds. And that question of belief comes into play of what happens the next quarter. How do you think about the difference between the reflexivity that comes from the investors redeeming and the underlying fundamentals of the loans in these portfolios?

• 29:38Speaker 00

  How does a normal person think about the fundamentals or some crazy bear like me? I've looked throughout my career for asset liability mismatches and I truly believe that asset liability mismatches cause liquidity crunches and liquidity crunches can cause credit crunches. Credit is correlated when it gets stressed. I have a good pulse on retail mindset in that this is an income product. That's why the private wealth channel cares about it. It's not like this is Apple stock. 10 years ago, private wealth loved MLPs. That was the income product. Then we had the energy crunch in mini default cycle

• 30:22Speaker 00

  in 2015, 16. Retail doesn't really care about MLPs. They will find their income product du jour. There's a sense of almost tied with retail. They like the product, the tide's in. They don't like it, the tide's coming out. If you think about how this redemption cycle started in Q4, we had Blackstone B-Cred, Golub's non-traded BDC and Oaktree's non-traded BDC, they all had to cut the dividend 10%. It made total sense. Sofa was down 175 basis points, new issue spreads were in, we had 300 basis points less than realistic gross yield of BDCs from 2022, 23 till now. You gotta cut the divs. Redemption's went from

• 31:04Speaker 00

  2.1% of the top six to 4.3%. There are financial advisors, wealth managers, whatever, RAs, they have a simple rule of thumb. You cut my dividend, I'm out. That's what works for me. I don't care if it's a blue chip stock. When you think about GE, that was a big blue chip. Cut the div, I'm out. I just have a 30-year history. That's how I go. Understanding that mindset is important in the understanding of reflexivity. They don't need this product. In order for managers to keep to stem the wave, they have to prove to The private wealth channel that first of all, everything's marked here correctly. And here's what we're investing in. Here's why we think we deserve your money. That has to be a really open conversation.

• 31:49Speaker 00

  The factors on who comes out of this wave the best. Underwriting is number one. Do you have a good loan book? Or is your loan book better than the market? Do you have alpha? Number two, risk management. Have you given yourself enough room to navigate? Can you sell a position? Do you have unfunded commitments that are going to trip you up a bit? Do you have enough of a liquidity sleeve? All those moves. The third factor of how transparent, how you communicate and how you instill trust with your investors is going to be a big one.

• 32:20Ted Seides?

  The scenario you described in Q4, rates come down, cut the dividends, very rational. The yields are going less on floating rate notes. The other side of the underwriting is the default cycle. And it's very different. Private credit, one lender, one company, they can defer, pretend extend, whatever it is. How do you think about how to measure successful underwriting as you're looking at the different managers that are offering these loans?

• 32:47Speaker 00

  You have to go line by line and look at where they have problem loans. How many of their loans are either marked below 80 or you think should be marked below 80? Hindsight's 2020. SaaS was the darling of private assets, whether it's private equity or private credit or even venture. SaaS was the darling of alts. If you're like, hey, I'm all in on technology. That's my thing. And there are some funds, non-traded or public BDCs. If you want that, this is what I'm giving you. That's what you signed up for. And we're in this period of how much is AI going to disrupt? If you think about economics, 80% gross margins, they're not going to last forever. Someone's going to try to figure out how to attack them.

• 33:31Speaker 00

  This whole, it's like switching costs. Clearly, technology is switching customers. People are thinking about that problem. But I would say portfolio construction, if you're not saying you're all software, I'm doing a technology fund, but I'm 50% software. Do all your investors realize that? Is that something that you have communicated to everyone? That's where you get to disconnect. We're going to have a wave of defaults in the software space. I don't think that's crazy to think about because we've had so much capital go into the space that from a venture or private equity standpoint, hey, listen, the upsides are so amazing that we can take some losers. We can still do well.

• 34:11Speaker 00

  Venture will tell you three out of 10 is good for them and they can take a bunch of zeros. Private equity doesn't like zeros, but they can take down 20% or some ties. When you're talking about credit, you take any zeros, it's tough or serious impairments.

• 34:26Ted Seides?

  If you look at signposts of the default cycle, you had defaults. You have some cash pay that moves to pick. How do you tease out where we are today?

• 34:39Speaker 00

  I think about credit cycles from the standpoint of misallocation of capital. In the early 2000s, you had a massive rush of capital into telecom tech space. That capital, whether it's global crossing or level three, laying fiber, cable. I'm glad they did it, but they did it a little too quick with the bad capital structure. So misallocation capital isn't necessarily bad. But in this SaaS space, it seems inevitable. Credit cycles are good for capitalistic economy. We haven't had one in a long time. So some of it's, do you really think we're never going to have one? I push back. Everyone's like, oh, we're fine. The productivity that AI hopefully transmits into the economy, there's going to be winners and losers. If you're long credit, you're short volatility.

• 35:24Speaker 00

  You want things to chug along because you don't have upside. Yeah, growth is okay, but you more want stability. When you introduce something like AI, the paradigm has shifted. You're going to have winners and losers. That shifting increases volatility. Higher volatility means more likely good and bad outcomes. And credit, it means spread should go wider. There should be some defaults.

• 35:50Ted Seides?

  A lot of the past cycles were funded by a significant amount of leverage. What are you seeing in the underlying fundamentals of the businesses as it flows through to what you're concerned about in the structures of some of these credit vehicles and leverage?

• 36:05Speaker 00

  The alt space is always trying to be creative and look for opportunities as to where to deploy capital. This idea of ARR loans, no one would have done that. You would have gotten laughed at a bit that you're lending to a company that has negative EBITDA and you're not getting any warrants. That was venture lending. You're doing venture lending without warrants. But SaaS had been a great model for a long time, but we're in a pro-growth space. It's pro-cyclical. I don't think ARR loans, they're good risk reward. They worked for a long time. Maybe some people did well with them. There are some investors that are great timers and they know it's bad risk reward, but they can ride a wave really well. But I do think we're going to have less ARR loans if we do get

• 36:50Speaker 00

  this software shakeout.

• 36:52Ted Seides?

  As these redemptions start to come in, if you were a GP of one of these funds and the redemption amount exceeded that 5% threshold, what do you think the best way to handle that situation is?

• 37:05Speaker 00

  Are you thinking about it for maximizing the fees of this fund? Or are you thinking about it in scope of a bigger picture? With B-CRED, Blackstone pretty much is the only alt manager that has gone through something. They have the experience of B-rate and they cleared that queue a short amount of time, sold assets, got some strategic investors to come in. They did a great job in clearing that queue. And now, it's not surprisingly, when B-CRED had 7.9% redemptions, they thought about it, "Listen, we're going to do everything we can to get everyone their money back." For Blackstone, that has 1.3 trillion and has deep ties in the private wealth channel,

• 37:48Speaker 00

  that was probably the best move. If you say on the other side of the equation, you're an interval fund and you're a manager and this is all you have, this one fund, maybe that's not the right move. Maybe you're supposed to only do the minimum you can. At the same time, if you're only doing the minimum, you do have to think, what happens for two or three more quarters? Are there risk management decisions I can make today that might be a little painful? And maybe I have to shrink my balance sheet. To get through this and grow, you have to at least consider the scenario where your AUM is shrinking.

• 38:29Speaker 00

  And during that period, you have to do the best you can in instilling trust and confidence in your investors to get through the tough times.

• 38:37Ted Seides?

  So do you circle back as the second thing that intrigued you when you were talking to Boaz about joining Saba, this something could happen big in this private credit space? How are you now thinking opportunistically about investing as some of these things are happening?

• 38:52Speaker 00

  It's been widely reported. We are tendering for one of the Blue Owl funds. They're Blue Owl OBD C2, which we're going to see if there is any demand for liquidity at a discount to NAV. It's new territory, so we'll see. We don't know if there's going to be demand or not. We think there is potentially demand. The space is $350 billion of assets plus another $100 billion of interval funds. So $450 billion plus some non-traded REITs. Big, big space. It's a small percent of investors that do get gated or looking for liquidity. It could be a decent opportunity to make an investment. If anyone else wants to top our bid, they can. It's not like we have anything proprietary in that regard. If we

• 39:37Speaker 00

  do become a shareholder, we want to be constructive. We hope for transparency, not only for us, but for all shareholders in every fund. That's the best way to get through this time. Through this stress, we're going to see secondary trading of private credit. How stressed that is, is TBD. It's starting to pick up a little more now. Obviously, it makes sense. Some of the best club deals that are the best credits are trading at par right now. If you want to buy any private credit loan at par, I'm sure you could get filled pretty quickly. We're thinking about that as well as potential opportunities.

• 40:12Ted Seides?

  What does it take in terms of research and flow from your team to be prepared to jump on something that could be? Very opportunistic.

• 40:22Speaker 00

  We're going through the filings line by line and trying to map out the capital structure as best we can to understand all the leverage in a particular, not every BDC is the same. There are some that are more levered, less levered, and then there's some that have CLO positions and unfunded commitments. So you have to stress, understanding the capital structure is important. You can do your best on trying to figure out what the right price of the credit is, but most of the BDCs are pretty diversified. You're thinking about one mark or two marks is not going to necessarily change the economics, but then also not taking at face value what the industry

• 41:04Speaker 00

  concentration are, literally putting in every loan into Claude or ChatGPT to figure out what do they think it is. There has been some mislabeling of concentrations.

• 41:16Ted Seides?

  If you put on your self-professed bear hat and paint a picture for how this goes from uncertain today to something that's a lot worse, what do you see happening from here to there?

• 41:31Speaker 00

  This is where I get all the hate on Twitter. Now you're stoking the fires. The bear case, which I'm not saying it's going to happen, but what happens is you get redemptions, you get some real defaults, you get for selling of private credit. And in the interval funds, you just run out of what's liquid and the bar to gate is really high. You literally need an SEC exemption and that's not because prices are low. You have to show the SEC, I don't have any liquidity. That goes on a feedback loop of where's the actual bid for private credit? It's hard to say a good bid would be in the low 90s for good stuff. Cause the absolute yields aren't that amazing.

• 42:15Speaker 00

  S plus 500 loan is 8% or 9%. It's got a five duration, so you're bidding 90, you're getting like 11%. One of the issues with private credit is all the returns are predicated at leverage at the fund level. You need fund level leverage to get anyone excited about it. If anyone came out with a unlevered BDC, it would be a yawn, especially after fees. JP Morgan marked down some software loans as far as their bank lender. That's the other issue is that going back before, are we worried about the top 10 managers? Or are we worried about the bottom quartile? When the rates were zero, you had some institutions that raised funds that probably weren't the most experienced or skilled investors.

• 43:00Speaker 00

  If their portfolios start getting seven or eight percent defaults, but some of the underperformers have 15 or 20% defaults in their portfolio, maybe heavy in a bad sector or so, banks are going to start cutting lines or not renewing lines. And there's an asset liability mismatch on the lines. Then the banks are going to pull back a bit and it gets a little harder for everybody. That's where you get the feedback loop on prices going down, which causes more redemption, less interest. Where is the clearing level from an unlevered level? Where do the distressed funds really come in? And it's probably decently low. You don't want to test that bid. Lastly, the worst, worst case scenario, which is far, far away,

• 43:40Speaker 00

  would be that there is lack of confidence in some of the annuity providers that have loaded up mostly on triple B rated private credit or better. But is there a potential where their annuitants start surrendering policies? That's the ugly, ugly. I don't know what the probability is. It's not a high probability, but that's where it gets bad.

• 44:05Ted Seides?

  You move down in the capital stack, eventually that has to hit private equity with a lot of these direct loans being sponsor backed deals.

• 44:13Speaker 00

  Yes, if you get a big default cycle, S and P is down, MSCI is down, so private equity has to be down. But there's going to be more variance amongst private equity than credit is more correlated. You're going to have tougher times because you have the fund level leverage and you might have to make a sale that you don't want to make and the upside isn't as much. Whereas if you're private equity and you have a portfolio company. That incorporates AI well, that could be a good one. Overall, the beta, private equity, if you look at just from the industry, the beta, yeah, it'll be a loser as well. This idea of asymmetry, the upside in equity versus downside in credit, I think that starts coming through.

• 44:58Speaker 00

  And then from the secondary standpoint, could you see some good opportunities in private equity secondaries? Yes. Could you see it in private credit secondaries? Depends on the vintage. The problem I have with private credit secondaries is how old are the loans? Cause the loans in typical seven years, but you hope to be refined three or four years. Once it gets past four years, there's probably a reason for it. I'm not saying that there isn't optimistic marketing in private equity, but you could have a company that's been in the portfolio for seven years and actually did take an upturn. There's less likely in private credit that that's happening. There's definitely a problem in private equity if you get a default cycle.

• 45:40Ted Seides?

  What do you think most investors in this space misunderstand the most?

• 45:47Speaker 00

  Liquidity. I understand private markets and I have investments in funds. There's some advantage as being an LP and not being tempted to trade. I don't need that temptation and that's okay. If you're a GP of a private fund and you don't need liquidity, you're like, these are my bets. I made these investments, but when you need liquidity or you get liquidity taken from you, that's where traders come in. There are firms that have more of a trading talent on the private credit side and there's some that don't. That's going to be the differentiator. When it goes away truly, whether it's during the GFC or the early 2000s around WorldCom

• 46:31Speaker 00

  Enron, all that stuff, it's always shocking. Even if you're David Tepper, who probably has traded those markets as well as anyone on the credit side, I'm sure there were like, oh my gosh, I can't believe I hit that bid and it's down 20 points. Everybody has a plan until you get punched in the face like Mike Tyson, that's liquidity.

• 46:48Ted Seides?

  What gets you excited each day when you're coming into the office now?

• 46:53Speaker 00

  I still like the puzzle. I don't want to wake up to Bloomberg and think about a position level, but the puzzle of the market, what's going to happen and how are problems going to get solved is still super interesting.

• 47:05Ted Seides?

  All right, Karen, I want to make sure I get a chance to ask you a couple of fun closing questions before we go. 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 Thema. For all the private equity managers out there, Thema uses AI to help map the landscape and source private businesses. It's incredible what a well-designed AI tool can do to accelerate the discovery of businesses in private markets. There's a link in the show notes so you can learn more. And here are those closing questions. What's your favorite hobby or activity outside of work and family?

• 47:45Speaker 00

  Playing basketball. I am old and I don't know how much longer I can play, but I love the game. I play at least once a week. I try to do everything I can to keep that going for as long as possible.

• 47:58Ted Seides?

  Which two people have had the biggest impact on your professional life?

• 48:02Speaker 00

  Two coaches, my junior high JV basketball coach and my high school coach, Tony Casamassa and Reggie Weiss. So many life lessons about how to be a good teammate. It's all about the team. It's your job to provide value to the team. After diving for loose balls, body language, defense wins championships, which is probably the best advice with respect to investing. Protect your downside.

• 48:28Ted Seides?

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

• 48:33Speaker 00

  Never lose your cool. Never yell or break a phone. When I started trading floors in the 90s, they were pretty rough and tumble and you always had to worry about getting picked off. I probably got upset more than the average person. I always apologized, but there's really no reason to.

• 48:52Ted Seides?

  Well, Karen, thanks so much for sharing your insights on what's going on and look forward to seeing what happens.

• 48:57Speaker 00

  Thank you so much. It's super fun to do this with you.

• 49:00Ted 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.

• 49:15Speaker 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.