Mastering Opportunities In Growth Credit & Venture Debt With Dan Zwirn, Part 1

 

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Welcome to another episode of The 7 in 7 Show with Zack Ellison, which features full length interviews with the world’s leading investors in innovation. The show this week features the first half of my interview with Dan Zwirn, a legendary hedge fund manager and one of the best credit investors in the world.

Dan co-founded Arena Investors in 2015 to bring creative solutions to those seeking capital in special situations. With a mandate unconstrained by industry, product or geography, Arena currently manages approximately $3.5 billion as a global investment firm focusing on special situations asset and credit investments in corporates, real estate, structured finance, and corporate securities. And Dan and his team have become well known for their ability to develop pragmatic, very precisely-structured investment opportunities in complex situations where others can’t or won’t.

Before founding Arena, between 2009 and 2015, Dan founded and/or led several specialty finance enterprises including Applied Data Finance (a consumer finance company), North Mill Capital (an asset-based lender), North Mill Equipment (an equipment lessor), and Lantern Endowment Partners (an investment fund).

In 2001, while a managing director and founder of the Special Opportunities Group at Highbridge Capital Management, Dan, along with Highbridge, co-founded D.B. Zwirn & Co., a global special situations firm. Dan served as managing partner of D.B. Zwirn & Co., which grew into a $6 billion enterprise. He had previously founded the Special Opportunities Group of MSD Capital, the private investment firm of Michael Dell.

Dan is a senior trustee of the Brookings Institution, a member of the Executive Board of the University of Pennsylvania Jerome Fisher Program in Management & Technology, and a member of the Board of Overseers for the School of Social Policy & Practice at the University of Pennsylvania. He previously served on the Leadership Council of the Robin Hood Foundation, the Board of Trustees of Barnard College of Columbia University, and the Board of Trustees of the New York Public Theater.

Dan holds a BS in economics from the University of Pennsylvania Wharton School of Business, a bachelor of applied science (BAS) in computer science from the University of Pennsylvania Moore School of Electrical Engineering, and an MBA from Harvard Business School.

In this episode, Zack Ellison and Dan Zwirn discuss:

1. The evolving venture debt market and its potential for investors.
2. The importance of being selective and disciplined in venture lending.
3. How market cycles affect venture debt opportunities.
4. Growth credit as a blend of venture lending, distressed debt, and direct lending.
5. The changing dynamics of venture capital and its impact on venture lending.
6. Strategies for de-risking venture debt transactions with a focus on cash flow.
7. Recommendations for investors to consider over the next phase of the economic cycle.

Mastering Opportunities In Growth Credit & Venture Debt With Dan Zwirn, Part 1

Welcome to the 7in 7 Show with Zack Ellison. I have with me Dan Zwirn, one of the world’s best credit investors and the CEO of Arena Investors, which is a $3.5 billion credit-focused hedge fund. Dan, thanks for joining.

Thanks for having me. I appreciate it.

It’s great to see you. You’ve done some amazing things in your career and I’d love to have you explain to the audience how you got here.

Meet Dan Zwirn

Thanks again. I’ve always been as much an investor as an entrepreneur. Fairly early on, I started thinking about how to be an entrepreneur within the investment world. In the early ‘90s, was reading quite a bit about the financial history and thinking about how people created an edge in durable franchises within the investment world over time. In 1995, I wrote a plan and did that, focused on the question of what makes an investment business a good business, having thought it through and looked at a lot of successful examples.

In every instance, it wasn’t about just having a person who could pick them in a speculative bet. It was about accumulating very specific access and resources that were defendable behind a moat that would give us or an enterprise in the area a sustainable edge. We came to think about this notion of a global chaser of illiquidity. We don’t just want to be a smart gambler. We want to be a great casino. What that meant was, in our case, thinking about three factors. One was the ability to avoid what is probably the most dangerous thing for any provider of capital, which is moral hazard, and to do so through a flexibility of mandate that allowed you to avoid things that were effectively overdone, overcrowded, and susceptible to that.

 

 

Number two, creating a very differentiated variable cost-efficient network that was hyper-aligned with the interests of the enterprise would allow us to go and create a very large funnel to which we could effectively apply this great risk investment mandate. Third, we’re rethinking through the back of the house and how do you create a differentiated advantage through the administration servicing, workout, and surveillance of these investments, and parenthetically, how do you apply technology to make that as efficient as possible?

As a result, I tended to migrate toward the event-driven hedge fund space only because, in the ‘90s, that was the only place where people had free-flowing mandates to do what made sense and avoid that. Through that, gained experience in investment areas, including risk arbitrage, distressed debt investing, what is now called direct lending or private lending, asset-based lending, real estate lending, etc. We did them in geographies across North America, Europe, and Asia as well.

I started cataloging in my mind a set of permutations of industry product and geography that I would dispassionately compare with one another to find where opportunity was. We did a large-scale hedge fund called Davidson Kempner, which was about $1 billion at the time and is now $40 billion or $50 billion. Quickly after that, it was backed by Michael Dell to build a business from scratch where I then learned things like how to set up the accounting systems, hiring and firing, the trading mechanics, and all the machinery or some of it.

It’s a nonstop learning process. Subsequently, we built a second version of that called D.B. Zwirn & Co. backed by Highbridge, which was later bought by JP Morgan. Now starting in 2015, the same thing at Arena, which was with whom I partnered with a Canadian holding company called Westaim, which is publicly traded under WED CN on your Bloomberg. Alongside a successful property and casualty insurance business, we’ve built Arena up from a few people and a small commitment of capital to where it is today.

How Structure Generates Outperformance

That’s great. One of the things that you’ve done well is utilize structure to also generate outperformance as opposed to just company picking or sector picking or riding momentum. What do you think about structure and how that can add to generating outperformance?

From my perspective, structure is intimately tied to control. We’re very focused on what is in and outside of our control. As people who are focused on deep value investing, I love value investing, the troubling thing about what I’ve seen in stock-oriented value investors is this notion that I’ve detected value. I’m sitting there looking at value. I’m hoping someone will unlock that value, namely the management or board of a given public company.

That leads to what people call value traps, where you’re sitting there owning $0.50 to the dollar and you can’t close the gap, so to speak. People end up screaming and shouting and proxy fights and letters to the management teams and going to conferences, touting their investment and why the sum of the parts is so much more valuable than where the stock prices, etc. Some people are experts at that. It’s not within our circle of competence. We’d much rather use structure to effectively put it all back into our control.

When we think about a debt instrument or a variety of different kinds of structured transactions, we don’t differentiate the notion of debt and equity because that’s an artificial construct. There’s a continuum of risk and reward in any asset. There can be multiple participants in that asset in multiple places in that capital structure. Each of them may have a very different return for a unit of risk based on where they’re setting up in that stack. The question about structure is not, “Am I dead or am I equity, etc.?” It’s, “Does this structure give me leverage in terms of control, no matter where I am in the stack to effectively crystallize value?”

That’s what we think about and think about when people have to give us information. What information do they need to give us? What covenants they might have? What approvals we might have? What discretion we might have? All the different tools at our disposal to make sure that no matter where we are in the capital structure, we’re in the driver’s seat for the recognition and crystallization of value.

That can happen in many different ways and also changes, depending on what industry you’re in, what country you’re in, what the applicable regulatory regime is, and the degree to which you’re exposed to a publicly traded entity, either traded stock or debt. There’s a lot of art versus science in terms of making sure all of those things are set up the right way.

Structure is intimately tied to control. Share on X

Key Investment Principles

What are some of the other key investment principles that you live by and that have helped you be successful over the last couple of decades?

I would say a very big one, and this came to me from a very smart investor, is alignment of interest. As Charlie Munger, who just passed away, always said, “Show me an incentive and I’ll show you an outcome.” We have seen innumerable situations where people have put themselves up a tree by giving people all the incentive in the world to put them up that tree. They scratch their head and wonder why they are up that tree.

What does that translate through to on a day-to-day basis? It means things like if I’m in a very difficult jurisdiction where, as an example, the system of creditors’ rights is limited but the system of title and ownership isn’t, I might say to someone who might want to borrow from us, “You’re going to sell me that asset. I’ll give you an option to buy it back from us over time.” Effectively creating a debt-style return for a unit of risk and structure, but putting all the onus of trust on the counterpart, which is a very tough jurisdiction, said counterpart will likely understand because if they were in our shoes, they probably wouldn’t do the same thing.

That’s just one example. This notion where you see folks as an example doing a dividend recap and letting an owner of an asset take out all their bait, but leaving you with all the risk and a cap return doesn’t seem bright. It happens all the time. There are arbitrages that very smart investors think about when they are on the borrowing side for example, or contracting side that are created by blips in regulatory rules and infrastructure, different incentives that investors might have to, as an example, accumulate assets very rapidly in the absence of a regard for the ultimate return pre-interest outcome for their investors.

As an issuer, I might take advantage of that. As asset and credit investors, we are borrowing as much as we’re lending because there are lots of people who want to finance us in the investments that we’re making. We’re always thinking about both sides of that equation. Innumerable arbitrage opportunities arise when you think about all the different things other than the return-to-unit risk that motivate potential providers of capital including arbitrary regulatory rules and stakeholder demands.

Even different perceptions around the investments that they want to create. They may not want to market down. They might want to market up. They want to do all these different things that have nothing to do with whether am I making a great return on risk. If one is on the other side of that, one might trade off some of those things that give these counterparties some non purely economic utility, so to speak, in return for increasing our economic utility.

That’s a great point about alignment. I always think about deals as needing to be fat, fair, aligned, and transparent. That’s how I always think about it. It’s very simple, but if they’re not those three things, you’re usually going to wind up having some fallout along the way.

To your point on transparency, we’re never getting over on anyone. We prefer things where everybody knows everything. We both acknowledge that we’re getting an exceptional return premium of risk, but the other person has some exogenous incentives that they understand they are trading off in order to give us excess economics. That’s perfectly fine. We do encounter folks who attempt to hide the ball, so to speak. We never react well to that. We’re never going to be a victim of that. On top of that, it decreases the credibility of the counterparty if they are going to operate in that manner.

It’s unhelpful in all ways. We’re not looking to do anything other than make a straightforward transaction. Warren Buffett, as an example, provided capital to Occidental over a weekend and gave them $10 billion in an incredibly low LTV, high return instrument. He was getting paid for being able to act over a weekend on $10 billion. It was an outrageous return on risk. Everybody understood it. I think the counterparty was delighted with it, just as GE, Goldman Sachs, and others were during ‘08. He got excess return and they got what they needed.

Transparency is key because as long as everything’s disclosed and it’s very clear what both sides are doing, it keeps you out of a lot of potential legal trouble too. In the sense that if it’s there and it’s disclosed, it’s a nice antiseptic in a sense.

It’s a condition precedent but it’s not sufficient. If you are back to ‘08 again exposed, there were anecdotes about people who sold things to unsuspecting buyers of mezzanine, synthetic tranches, etc. When in fact, everybody had the same in-text runs, in-text for anyone who doesn’t know is a software system that allows you to analyze asset-packed securities in certain ways. One side had a view and the other guy had a different view and one was right. The wrong person then retrospectively cried fraud or misrepresentation or misselling as opposed to they didn’t do their homework. The consequence was logical.

 

I think there are a lot of folks who after things go bad, want to blame somebody else. They don’t want to take personal responsibility or accountability.

Quite a bit of that.

In addition to fairness, alignment, and transparency, what are some of the other investing principles that have served you well?

In everything we do, we’re always thinking about one of two things. Do I have a Buffett-style five forces moded franchise that is highly free cash flow generative? Parenthetically, am I creating a yield with that post-loss on leverage cashflow that is appropriately high relative to alternatives and risk-free, or we’re looking at understandable assets that are liquidatable? Furthermore, getting down to the first principles, several people who are asset-oriented get stung when they go, “Everybody buys my asset for X and it must be worth X and I’m advancing 0.8 of X.” Suddenly, the asset’s worth 0.6 of X and everyone goes, “How did that happen?”

The answer, of course, is every asset only has value insofar as it can produce a post-tax unlevered cashflow. Otherwise, it has no value. There’s certainly no economic value. It may warm your heart like gold, but it has no intrinsic economic value. Sticking to that first principle of what yield does this asset or enterprise or piece of property create? How does that yield on an unleveraged basis compared to all other alternatives, including risk-free is a great place to start.

It seems obvious, but a lot of folks put that to the side when they were shoveling money out the door in late 2018 leading up to the end of 2021 and are now saying, “Wait for a second, it’s going to be many years until this technology, this asset creates real cashflow.” No one values that cashflow relative to hard cashflow as they have. By the way, whatever cashflow it might have had or even does have relative to alternatives or risk-free, now that risk-free is fundamentally changed is relatively unappealing.

What was I thinking? The hallmarks of multi-decade highly successful investors are that this passionate look at what is the basic understandable yield that is derived from this thing. It doesn’t mean, again, that whole Buffett-Munger issue of buying a great business at a good price versus buying cigarette butts. Both can work. One could argue even that the mechanism by which Buffett and Munger did the former was powerful.

You sit on your hands and you own a bunch of money machines, you pay the premium form, but they keep working for you and they keep working over time and memorial. That makes a lot of sense. You can create a cigarette butt buying machine which in some ways we’ve done and effectively tried to make our enterprise itself a highly free cash regenerative enterprise with a moded franchise, but it depends.

Current Market

In the current market, are there particular areas that you think are very appealing?

I would look at the market as a group of different opportunities. If you want to create a scaffolding upon which you could hang your perception of where opportunities are and aren’t or might be, I think about, first off, the combination of the tremendous asset bubble that was created starting in 2012, which is the wholly unnecessary and highly inappropriate, effectively intervention in the market by monetary authorities to suppress rates at a time when it wasn’t an emergency and it wasn’t appropriate. That created what is now the largest asset bubble that’s ever been.

Starting in 2020, and starting in our country, but in many countries around the world, we saw a significant increase in the degree to which there was a wholesale governmental commitment to the destruction of fiat currencies. Going back to Munger, show me an incentive and I’ll show you an outcome. What do monetary authorities want to do? They want to leave a good legacy and get a lot of sinecures and pass off the problems to the next guy. What do politicians want to do? They want to get elected, period, full stop, and they’ll mortgage the future and their grandkids and our grandkids’ futures for that purpose.

When something produces cash flow, the pressure to gain liquidity is a lot lower. Share on X

As a result, you have the consequent inflation that has arisen for the first time in many years, mixed with high rates. You have a high likelihood, given the degree to which the tools that the monetary authorities would otherwise be able to use or a recognition of the lack of inflation are gone now.

You have a high likelihood of what is now called higher for longer. A higher for longer combination, not only of rates but also inflation, as the government wants to inflate as much as it reasonably can without causing problems on getting elected in order to decrease the amount of liabilities that have already incurred by having this asset explosion that it created. What that means is, in real estate terms, cap rates need to be higher and values need to be lower. In corporate terms, evaluation multiples are going to be lower.

That creates two broadly defined two big opportunities that we colloquially refer to as a barbell. On the right side of that barbell are opportunities to be a beneficiary of the wholesale rationalization of the balance sheets of corporate property and structured assets all around the world. They may be very reasonably well-performing ones, but they were just bought at too high a price and lent to at too high a level, and therefore that needs to end. It will end as an arithmetic factor of the matter. You’re seeing that in many areas.

On the left side of the barbell, you now have opportunities to reenter markets that were abused by the whole-scale explosion in alternative assets, where the incentive was to accumulate assets as fast as possible. Let’s deploy them as fast as possible. Let’s raise the next fund as fast as possible. We’ll deal with it at the end. Now you can re-enter those markets where the return-to-internet risk is far more favorable as a number of those competitors have either overdone it or otherwise reduced their participation in the market.

The question is where are the elements of that barbel happening? I would argue to you that there has been a slow-moving process by which different investment areas or even geographies have been more affected by some hard catalyst that precipitated a recognition of this value disparity that has been created in the marketplace. Left to their own devices, no one will have volunteered that they made the mistakes that they did.

In late ‘21, first off, we had the factors of the matter arising in the growth and venture world. Why is that? Because people needed cash because they were burning cash. That forced the recognition of, “There’s a problem.” We saw the barbell opportunities emerging of the small number of enterprises who had feasted on negative cost equity, who had built actual franchise value and maybe even cashflow positive, who were much lower value than they were before, but might provide new opportunities to invest equity or debt at much more favorable terms.

You saw the left side of the barbell where the bar to raise seed series A and series B was much higher. Therefore, the asymmetry and the potential investment in venture debt, where I know you’re involved is much more favorable, much more in favor of the investor. In the middle of the barbell, we saw what venture capital has recently referred to as a mass extinction event.

On the one side, you didn’t make it to the other side of having real brand value franchise and franchise cashflow positive and ubiquity of some sort. You’re not one of the shiny new baubles with the two new magic letters A and I. No one cares. If you’re Bitcoin or Nano or blockchain or some other form of yesterday’s news, no one wants to know you anymore. All of those enterprises are getting obliterated because no one cares.

Number two, I thought in 2022, we saw in the fund’s universe the beginning of a new secular and very compelling investment opportunity, which is that as a result of this gorging on alternative assets, never before have as many institutions owned as much of a volume of LP investments across the entire alternative universe. That has meant as they realized, “Wait a second, these assets can have a much greater duration than I ever imagined.” Suddenly they said, “How am I going to service my annual draws and endowment or my insurance settlements as an insurer or the pension obligations or what have you?”

They start selling or start to rationalize a lot of their portfolios. If the growth is at the bottom of the first, the LP stuff is at the top of the first. It is a massive opportunity. It’s not an asset class, even though our space loves to slap the term asset class on virtually everything it can because any productization opportunity is another way to sell something.

 

The reality is it’s just another way to wrap collateral. We see a lot of these large-scale allocators in some ways as banks that have to rationalize their balance sheets. Instead of owning loans on these assets, they own LP interest in them. There’s going to be a tremendous amount of opportunity around that.

Number three, starting eight months ago, we saw things like Silicon Valley Bank and First Republic where people said, “Wait a second. Suddenly my deposits can move around in a way I never thought.” They’re not as stable. By the way, in the wake of the over and misregulation of the banking system post the GFC, we were all told to invest in securities and real estate loans because that was safe. Of course, they went way long on their securities in order to reach for yield and subject themselves to interest rate risk to staggering proportions.

On the real estate side, they overdid it, too much advance to not the right borrowers, etc., with a highly exposed rate risk as well that was harder to understand. If I’m buying 15-year bonds, most people can go, “Wait a second, if rates change, there’s going to be a heck of a change in the values, which is why you see large-scale banks with a hundred billion dollar not mark to market losses that they’ve not recognized.”

On the real estate side, it was a little harder to discern, which was in addition to the obvious secular issues that we have in office in certain parts of retail, we have this cap rate issue, which is effectively an interest rate risk that wasn’t hedged. As rates are perceived to be higher for longer, cap rates are higher, value is lower, advantage rates are too high, and effectively there are impairments.

They haven’t been recognized in many instances, but I think you will see that coming. Again, right side of the barbell, you’re going to see huge amounts of distress. A lot of loans coming off of boundary as well as out of alternative investors who themselves have financed themselves frequently on a non-asset liability matched basis with Wall Street rediscount lines of sorts.

On the left side of the barbell, you’re going to see new issue opportunities and we’re seeing them today that are exceptional. Generically, you’re looking at straightforward real estate where three years ago, people were advancing 80% on a five-cap asset and a five-year deal to make 6%. Now they’re doing 65% on an eight-cap asset on a two-year deal to make thirteen. Even risk-free adjusted, the spreads have increased significantly and are very favorable and have the additional benefit of being relatively more homogeneous, easy to effectuate, and scalable. We like that a lot.

Next is corporate at the very beginning. The market participants are always innovative around effectively hiding price discovery. Market participants hate price discovery. As an example, we have talked to bank lenders who have said, “Look, I’m not sending my bad real estate loan to the workout department because that means that that’ll trigger an appraisal and then we’ll have to mark the loan. We’re going to have to put up more capital against it. It’ll be ROI negative and that’ll be like that.

Similarly on the corporate side in leverage loans, unfortunately, it was not well recognized the interconnection between CLOs, leverage lending, direct lending, and middle market private equity. The fundamental misselling of leverage loan performance based on a rearview mirror 60% recovery post-GFC was used to sell CLO interests, which effectively, when paired with very low-cost AAAs from large-scale global insurers, created a tidal wave of lending desire, which meant that people were lending more, earning less with worse covenants and funding private equity sponsors who were then able to pay more, assuming the availability of very cheap debt.

That created debt that was much worse in quality than it was pre-GFC, which will likely have recoveries that look more like 30 and 60, which means that this whole thing is going to unwind the other way. Now there have been a whole series of different mechanisms in the marketplace like the control of leverage loan information limited only to people who are already in the loan. Therefore, it’s hard for new people to buy and therefore hard for new people to price or things like what they call white lists, where only certain people are allowed to ever buy the loan, including people from pricing the loan or different agreements among lenders where they say, “No, we’re all going to sell together or not.” Again, stopping the sale.

As Ben Graham, Buffett, and Munger tell you, “In the short term, it’s a voting machine, and in the long term, it’s a weighing machine.” All of this will come home to roost. This whole cycle is unwinding itself and it’ll be precipitated by, I would guess, the agencies, where unlike value investors in credit who think about leverage and severity, agencies and banks and regulators think about defaults and coverage. Why don’t we care about the defaults? Defaults are not losses, they’re just defaults.

Just because a thing is permitted to trade on a market, it doesn't mean it will trade on a market. Share on X

If you make hard covenants, you’re going to have lots of defaults and that’s okay because you’re going to have fewer losses. In the case of why do we care about leverage and not coverage? We want to lend as little as possible and make as much as possible. Coverage means how much cashflow of an asset covers your interest. If we charge low, we get a very low rate, we can create very high coverage levels. That doesn’t make any sense because we want to charge high rates and have low coverage levels.

What’s happening is now with the increase in risk-free, the agencies who focused on coverage are saying, “There’s a lot less coverage of cashflow on these now escalated rates.” We’re going to downgrade, which then in turn creates the possibility of effectively forcing long only and other alternative types to put more capital against these assets, which then effectively creates a pricing mechanism. Finally, recognizing that in most instances, the agencies are plus or minus eighteen months late to any party with regard to credit quality.

Finally, in structured finance, we’ve seen tremendous changes in delinquency rates. Again, a whole variety of ways and reasons why those are not marked appropriately. Those are chickens that are coming home to roost as well. If you look at where payment data regarding unsecured credit cards, car loans, residential mortgages, etc. That’s as well as other non-consumer structured finance assets. That’s what’s happened.

Commercial Real Estate

There’s a lot to dig into there. Let’s talk a little bit about real estate and commercial real estate, what that means for bank balance sheets, and what that could mean for capital availability. In simple terms for people, how would you frame it out in terms of the pressure on commercial real estate and what’s been happening to date, and also what’s going to change in the sense that valuations are going to have to start to change? A lot of people have been finding ways to avoid marking their books to the true market value, but that can’t persist forever. In a very simple term, how do you think that the commercial real estate sector will impact bank balance sheets and what will that mean for the broader economy?

It is interesting because this CRE has found itself in many different nooks and crannies within the overall marketplace and not in a lot of non-obvious ways. Meaning, yes, of course, post-GFC, the banks were all told to do CRE lending, so they did it. Also, there were global investment trusts of various sorts with daily liquidity that invested in huge amounts of commercial real estate, even though it was completely illiquid and levered to the hill. You’re seeing certain headlines now of folks in Europe who were involved in some of those things.

Furthermore, within the alternative space, the alternative marketers came up with this fabulous term called core, which was called in today’s language and would be thought of as a dog whistle for low risk. If I call it core, the investors hear low risk. They bought high-quality real estate or what they perceived to be high-quality real estate at the time at incredibly high prices or low cap rates. They financed it with tremendous amounts of leverage at what was then lower rates and then proceeded, because of the asset independent of its price or capital structure, to call it core.

People then said, “If I’m buying something that’s core in a low rate environment, if I make 6% net to me, I should be super happy.” Now lo and behold, they weren’t thinking, “By the way, I’m going to make 6%, but my downside is I’ll lose all my money.” They were thinking very little downside because that dog whistle allowed them to think in their heads that they owned a great asset, never mind the price exactly and I’m not exactly sure how the leverage works. It’ll be okay because after all, it’s called core.

All of those chickens are coming home to roost because the values are different. By the way, they came home to roost. The value of the munitions started 2 or 3 years ago with COVID and the fiscal destruction that began in early 2020. Finally, people are forced to recognize it. You’re seeing it in these trusts. You’re seeing it at the beginning of the accumulation of reserves at banks. You’re seeing it in certain types of REITs that have halted redemptions because of these issues, and you’re seeing it begin in CNBS prices.

It’s creeping out in all the little cracks that it was stuffed into. It’s still very early. As I said, as an example in the US on the banking side, on the new issue lending side, the banks have already made themselves scarce. There are wonderful opportunities in that regard. On the right side of the barbell, where you’re talking about the rationalization of those assets, that hit their radar recently enough that they weren’t in a position to be able to continue to report strong earnings while also taking those losses.

We’ve already started to see major banks who, surprise, have reported strong earnings, but greater reserves than they were expecting. That’s not a big mystery. They’re going to continue to make a net interest margin on all of their assets as much as possible and build up those reserves that’ll then allow them to take those losses while they still manufacture earnings that seem steadier than they are.

If you were hard-marking the market, it would be very brutal because banks are calling it between 10X and 20X leverage. That means small changes in underlying asset values can be very material. Furthermore, they’ve had the additional problem of, “By the way, the market used to value my demand deposits higher than my term deposits because they had historically stayed longer than the term.” When you and I can move where you put your deposits at the push of a button on the iPhone, suddenly that changes things a lot.

 

Now the right side of my balance sheet is completely destabilized. I’m loaded with these assets over here that are now worth a lot less. That whole process is beginning to show itself. There are versions of that internationally. I would say, much more so generically in Europe for all of this. Do we see things that are similar to the US? I think Asia Pacific for a variety of reasons is going to be delayed, but it’ll be common there in 6 to 12 months in our view.

You hit on a great point about the velocity of movement in the sense of cash movement that in the past bank runs were easier to quell, and now they can happen overnight like they did with SVP because social media gets ahold of a story. People can log into their iPhone or computer and press a couple of buttons and voila, all those deposits are somewhere else. That’s a real risk that nobody on the regulatory side anticipated or did anything to mitigate. That’s something that’s changed structurally that then impacts the speed that these bank runs can occur at.

One of the things I was wondering as well is what you touched upon. We’re talking a lot about liquidity. People who have liquidity or funds that have liquidity, institutions that have liquidity are going to be in a very advantaged position going forward in my view, because I think liquidity is going to dry up a lot. Certainly, most people are not ready for how much liquidity is going to be sucked out of the system. How do you think about liquidity as being a tool to generate high returns versus just being smarter, being a better forecaster, being a better picker of industries or companies?

Liquidity

It goes back to what we talked about with regard to the underlying assets themselves and the degree to which they produce cashflow. When something produces cashflow, the pressure on me to gain liquidity is a lot lower because it’s producing cashflow. If I have a pool of assets that themselves produce cashflows that are as uncorrelated to the overall market as possible and as uncorrelated amongst one another as possible, then I certainly have a base upon which to work.

We look to that underlying cashflow production capability. We’re very focused on intrinsic duration. Having the duration equation move to our side, meaning one of the other many unintended consequences of the GFC and the bubble that ensued post that was that duration was systematically underpriced. There are some structural reasons why there are perceptions among certain types of, for example, life insurance investors that they tend to care much more about reinvestment risks than they care about duration risk.

That leaves them leaning one way, so to speak. We’re going to lend with type maturities and type covenants and the ability to access assets quickly and monetize them quickly. We’re going to demand that access and effectively charge a very high premium for, “illiquidity.” I think there’s going to be a recognition in the market. Ironically, there’s still a great perception that dog whistle core means risk-free and CUSIP means liquidity. For your audience, to be clear, a CUSIP is something that is put on top of security, equity, or debt or preferred that allows it to trade on a market.

Just because a thing is permitted to trade on a market doesn’t mean it will trade on a market. furthermore, just because something trades on a market doesn’t mean it’ll always trade on a market. Many assets will trade on a market during good times, but will suddenly not trade on a market during bad times. One of the additional many unintended consequences of the over and misregulation of the banking system post the GFC was that banks were penalized for providing market making.

For your audience, what does market-making mean? This means you need people sitting in the middle of markets saying, “I will buy and sell,” in order to facilitate that liquidity. Yes, you can use dark pools and technology and make that work in a lot of stock situations, although not all, much harder in fixed income. Fixed income is much bigger. There is a significant left tail risk that if something unexpected happens in the markets, we may have an effective ceasing of the provision of liquidity over an extended period of time as we had in the back half of ‘98 in the wake of the Russian default and the Thai Baht crisis in Asia. Furthermore, ironically, we may see some liquidity pop up that we didn’t know we had.

While certain fixed-income instruments that have CUSIPs may not have liquidity, what we’re seeing is ever more liquidity available in what are regarded as purely private assets through the secondary markets. There’s been an unbelievable lot of capital raised by some of the very same people who were incredibly aggressive during the bubble to then go and buy theirs and others’ LP interests that were aggregated during that bubble.

As an example, you might be on the board of an endowment and say, “The NAV statements on our CRE equity say that they are at point eight of our original commitment level but you might see that the secondary market for that very same LP interest is trading at $0.50 on that $0.80. At some point, one, you’re going to see a lot more of this trading of these interests. Some very significant endowments have engaged in these transactions already at levels significantly below NAV, at the stated NAV from the general partners. Consequently, you see a world where that which is perceived to have liquidity doesn’t, and that which is perceived to not have it does. A lot of secular changes are happening as a result of the intervention in markets as well as the evolutionary alternative space that creates new ways of looking at things.

 

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About Dan Zwirn

Daniel Zwirn began his investing career in 1995. Dan founded and built D.B. Zwirn & Co., one of the largest independent firms in the alternative credit space.

He has participated in over 3,000 illiquid investments in 25 countries, accounting for over $10 billion. Dan most recently founded Arena Investors and is the firm’s Chief Executive Officer and Chief Investment Officer.