Macro Shifts & Best Ideas Coming Out of the Pandemic with Todd Lemkin, Partner & Chief Investment Officer, Canyon Partners. Peter Wallach, Executive Managing Director & Head of Risk Management, Sculptor Capital. Jason Mudrick, Chief Investment Officer, Mudrick Capital Management. Leslee Cowen, Management Committee Partner, Credit Funds, Fortress Investment Group.
Moderated by Troy Gayeski, CFA.
SPEAKERS
Todd Lemkin
Chief Investment Officer
Canyon Partners
Peter Wallach
Executive Managing Director & Head of Risk Management
Sculptor Capital
Jason Mudrick
Chief Investment Officer
Mudrick Capital Management
Leslee Cowen
Management Committee Partner, Credit Fund
Fortress
MODERATOR
Troy Gayeski
Former Partner, Co-Chief Investment Officer & Senior Portfolio Manager
SkyBridge
TIMESTAMPS
EPISODE TRANSCRIPT
Troy Gayeski: (00:07)
Hello, everyone. It's great to be here at SALT. We were going through many iterations of how to start this panel out, but given the immense impact that the pandemic had on capital markets, the economy, society, and given that this is the first time we've all been together at this incredible celebration of investment excellence, we thought we would segue back to that and walk through what was going through the minds of some of the greatest multi-strategy distressed credit and value investors on the planet as the pandemic start to kick in impact markets and as the recovery began. So without further ado, I want to start with Peter Wallach at Sculptor. We're starting there because Sculptor, as you probably know, has an incredible focus on risk management and that happens to be his title. So Peter, as the pandemic started to evolve from just being a more of an epidemiological problem to more of an economic and market problem, how are you guys managing that process? What was going through your mind? How were you trying to protect capital during the acute stages of the debacle?
Peter Wallach: (01:10)
Thanks so much, Troy. Wow, it seems like ancient history, but it's still also a little bit fresh. So, we have a global reach at Sculptor, and one of the things that sometimes differentiates us is having that global reach is the ability to have a bead on certain theses in various corners of the market. We felt very fortunate in the February timeframe of 2020 to develop a proprietary, and at the time, thankfully accurate thesis on the scope and potential impact of the virus and as is as is our typical practice, the combination of active risk management, portfolio management, and a lot of hedge overlays sort of combined to allow us to really take down risk in a hurry, and what that means is we cut all market value by half.
Peter Wallach: (02:07)
We cut our beta to basically zero, our net to zero, and that really allowed us to play offense for a good portion of the early days of the pandemic in February, March, and April. And, when the dust had settled, it seemed like one of the biggest opportunities was really getting off of the inertia and getting out of the sort of paralysis and deciding where to invest and where we decided to place our chips where we thought the highest and best use of capital was, was in safe spread across the globe. So, that's in corporate credit and structured credit, blue chips in credit, and in very seasoned borrowers in structured credit and mortgages were offered hundreds and sometimes thousands of basis points wide to where they had been into fundamental value. So, within it seemed like a cup of coffee, but in very short order, we had doubled our global credit exposure in the fund, and then over the remaining part of the year, we did the same within equities and convertible and derivatives, but really it started with what we thought was a very compelling opportunity in some blue chip areas.
Troy Gayeski: (03:19)
So Peter, the key point there would be help protecting capital on the way down helped you to go on offense on the way up, and you started with investigated credit and worked your way down the capital structure from there.
Peter Wallach: (03:28)
That's right.
Troy Gayeski: (03:29)
Now Jason, segueing to you, you're known as more of an alpha generative guy, big idea guy when it comes to idiosyncratic opportunities. How are you managing that process, given the much more idiosyncratic nature of your portfolio versus some of your competitors?
Jason Mudrick: (03:44)
Well we're all, but we're distressed credit investors and you have to understand in March of 2020, we went from a relatively benign environment for distressed credit to having the largest quantum of distressed credit we've ever seen in the history of the world over the course of four weeks. There was literally $1 trillion, and I'm not just saying that to be dramatic when people use the word a trillion, it was actually $1 trillion of distress credit in the US by April 20th of 2020. So that was one, two, a lot of these businesses were completely healthy a month prior. So normally in our business, these capital structures break down gradually over time and you have a lot of time to diligence them and prepare yourselves. Names don't go from 100 to 50 overnight, they go from a 100 to 90, to 90 to 85, and you're starting to do your work and hire lawyers and do all this stuff, so that you have conviction to invest in these capital structures when they finally break down. That didn't happen. We didn't have that luxury. A lot of this analysis needed to be done from scratch businesses.
Jason Mudrick: (04:42)
Businesses we'd never even heard of that now had first lien debt trading at 50 cents. Three, a lot of the tools that we use to invest in these capital structures, our firm, we like to roll up our sleeves and get on airplanes and go meet with management teams and walk factory floors and talk to competitors and talk to suppliers. You couldn't do any of this. We were forced to be desktop analysts, which that's not our style. And, also the way COVID impacted a lot of these businesses was like nothing we had ever seen before. I've been through a number of recessions and you see revenue go down 20%. There was industries where revenue went down 100%, more than 100% if there was contra revenue accounts. If you were investing in casinos or restaurants or gymnasiums or movie theaters, these businesses saw revenue literally go down 100%.
Jason Mudrick: (05:27)
There's no case study in business school to say, here's how you analyze these types of businesses. And then finally, and not to state at the obvious, but while all this was going on, while you had the largest quantum of distressed credit ever, we were all told to go home and work remotely. And while we all got pretty good at that over time, initially when there was the most acute amount of distress, we were all figuring it out. We were using Skype for Business. Nobody even knows what that is anymore. That was the video conference system that was downloaded on all our PCs and trying to figure out how to work at home with your kids running around and your significant other in the other room, the emotional stress and trauma that COVID impacted, particularly on younger analysts, it was very challenging.
Jason Mudrick: (06:07)
So, what did we do? What can you do? You just put your head down and work. I sat around with my team very early on and I said, "Look, guys, this is our time to shine. It's not like you guys have anything else going on. We're all just sitting at home doing nothing. So, let's just spend the next six months working as hard as we've ever worked." And, that's what we did. We did 12 to 14 hour days every day, including weekends for the first 90 days. We drew all of our committed capital down, took all of our cash and our open-end vehicles, and by the end of June, all of our funds were fully invested in. There's a positive end of this story. While it was incredibly stressful and intense, it ended up being very fruitful because those funds did very well over the ensuing 12 months.
Troy Gayeski: (06:46)
It's great commentary, Jason. So Todd, we watched you in real time put the foot on the gas in late March, early April and really seize opportunities that you hadn't seen really since the global financial crisis. Can you walk us through that mindset as you're coming off a tough period and then it's time to go on offense and go after the most opportunistic targets you see?
Todd Lemkin: (07:10)
Sure, thank you. I echo some of the comments here. I think the biggest struggle was really trying to figure out the timeframe. All the scientific experts were telling you this was going to go on for some time, you had no visibility on vaccines obviously in that timeframe. Any sector that was remotely touching on the consumer or gathering of people, be it retail or gaming or-
Troy Gayeski: (07:35)
Airlines.
Todd Lemkin: (07:35)
Travel, airlines, any of that, you're sitting there going, "Okay, these businesses are literally running at zero revenue." And so, it wasn't stress testing a company for an economic downturn, it was stress testing a company for how many months of liquidity do they have with zero revenue. And not surprising, particularly in the gaming industry or some of these other industries, there's a lot of fixed costs, a lot of operating leverage in these businesses. So, they didn't look like they had a whole great degree of running room.
Todd Lemkin: (08:02)
We tried to be very nimble. We rotated initially into a lot of these higher blue chip investment grade quality credits. You could buy Coca-Cola, you could buy Apple, you could buy Boeing bonds, things like that that seemed like good initial expressions. And then as we got, I think, some more comfort and some more visibility into how to think about the virus by sort of May, June I'd say, we definitely started rotating more into the travel and leisure space focusing on top of the capital structure under the theory that if they did run out of liquidity, at least we were, from a loan to value perspective, well collateralized or well covered we felt. We also focused a lot on structured products. There were some very interesting opportunities. Naturally, those structures were levered and very exposed to the initial shock of the crisis-
Troy Gayeski: (08:55)
The consumer, the housing market-
Todd Lemkin: (08:57)
Exactly. There was some mortgage lenders that had needs for media capital that by almost the time we were putting the documents together had already really started to come out of it because the Fed acted as quickly as they did, but those were some pretty interesting opportunities as well. It was challenging, and I agree with Jason, we just got to a point where you couldn't go out and see the companies, you couldn't really touch and feel what was going on, which is ordinarily what you'd like to do. In many cases, you couldn't reach other people involved. They weren't in the office and that sort of thing.
Todd Lemkin: (09:30)
So, you really did just kind of put your head down and try to power through it. Every day was intense there for several months. It really wasn't until the summer that it felt like there was a little bit of calm. You could take a breath.
Troy Gayeski: (09:43)
Somewhat more normalized.
Todd Lemkin: (09:45)
Exactly, but the timing still to this day, is part of the struggle, and I was reading this morning we're 20 months into this disease, if you want to call it that. They're talking about potentially new strands coming from Africa. Without [crosstalk 00:10:01] liquidity in the system it would have been a very different dynamic. I think it would have dragged on quite a bit longer.
Troy Gayeski: (10:07)
God bless the Fed and the fiscal stimulus, right?
Todd Lemkin: (10:09)
Absolutely.
Troy Gayeski: (10:11)
So Leslee, we were joking around before the panel started about given the nature of what you guys invest in and the fact that it's not market to market as frequently, you weren't as concerned about market to market risk. And I asked you, what were you sweating? And, your answer was?
Leslee Cowen: (10:26)
We were still sweating it all. There's no question-
Troy Gayeski: (10:29)
Sweating everything, and that was the key, right? So, given how great Fortress as a firm is at investing in special situations credits, can you walk us through when you as a firm and yourself became comfortable that many of those credits would make it and end up having really attractive realized value, because obviously mid-March, much more stressful, maybe by April you started to feel a little bit more comfortable?
Leslee Cowen: (10:54)
Yes, and as everyone has said before, it goes without saying we were all dealing with personal and professional challenges, and the immediate thing was to make sure everybody was safe and then also to figure out how to work logistically from home because that was a new phenomenon for all of us. And, what we decided and realized quickly was that we had two agendas. One was to preserve capital and protect our existing investments, and the second was to capitalize on what were opportunities, the likes of which we hadn't seen since the financial crisis. And so, we needed to do both, and we made an immediate and very important decision, which was to invest aggressively and decisively rather than proceeding with caution.
Leslee Cowen: (11:36)
And with that as a backdrop, based on all of our prior experiences and the multiple cycles we've been through, we mapped out for ourselves what we considered to be or expected to be the three phases of dislocation. The first was forced liquidation in which expected to be taking advantage of opportunities on the back of margin calls, redemptions, and fire sales. The second was illiquidity in which we expected there to be short-term cash needs in order to fill gaps, and in order to feel the void where the capital markets were otherwise closed. And, the third phase of dislocation we expected to be reconstruction in which companies were going to then have to rebuild their balance sheets and move on to the post-COVID world. So, what we determined was that March and April really were that first phase of forced liquidation, and they were quickly followed by the phase of illiquidity, which went through the fourth quarter of last year. In that whole timeframe, we were able to deploy approximately $10 billion.
Troy Gayeski: (12:45)
Wow.
Leslee Cowen: (12:45)
And, it was a pretty major effort and the reason why we were able to do that, and we were really able to invest right out of the gates starting in March, and the reason for that was that we have a team of 160 investment professionals worldwide, and we gathered them all up together and that team has an enormous laundry list of names and library of names that they knew of credits, assets, securities of all kinds. And so, people went back to the names they knew. They went back to what we consider to be the low-hanging fruit and started out really with stressed and distressed securities in the corporate world and asset backed securities. We looked at broken mortgage rates, et cetera, and we found opportunities based on names we already knew.
Leslee Cowen: (13:31)
So, we weren't starting from scratch. This was not original research. This was reviewing names and we were able to go back and assess the names that had the best risk reward and pursue them immediately and we were able to fill a void where there was otherwise no capital available. That quickly then transitioned into investing in direct lending and buying into liquidations and buying other types of assets along the way. And, that's really how we transitioned. And then ultimately, I think we feel like we called those three phases of dislocation pretty well, and if there was one mistake we made, it was actually the timing. It went way quicker than we ever would have imagined.
Troy Gayeski: (14:11)
And, you would have preferred it to go slower, so you could deploy-
Leslee Cowen: (14:12)
Of course, the Fed came in and took our jobs away, but the truth is that the phases went very quickly. And so, the only regret is maybe if we could have invested more we would have, but time ran out. And that being said, we've now moved into that phase of reconstruction and that's where we are today.
Troy Gayeski: (14:31)
So, why don't we segue now into the present? I think we all know that the macro economic environment and capital market environment is incredibly different than what we're all discussing. You have a Fed that's already starting to pull back liquidity underneath the scenes. A lot of people aren't aware of how much liquidity has been sucked out of the system already, and how much money supply growth slowed. You obviously have a situation where GDP estimates keep getting ratcheted down, revenue growth, earnings growth, more uncertainty than usual in DC around future budgets. So, in an environment where equities are 21 times forward earnings, absolute yields on high yields are 400 basis points. Can anyone in this room even imagine that two years ago? Where are you finding opportunities today? And Leslee, why don't we start with you again? You can jump in first here. You started to touch upon it briefly, but my understanding is a lot of it is off the run esoteric credit where today's best opportunities are in a world where vanilla assets are fairly richly priced.
Leslee Cowen: (15:36)
You're absolutely right. As I mentioned, we are now in the phase of reconstruction, and then in some cases, even we've moved beyond that in certain sectors. And so, there were lots of distressed and stressed opportunities in the public markets last year, and those have largely been resolved. So, we have now regrouped and refocused our efforts on what we consider to be private credit. There are three areas that we're focused on in particular these days that I'd like to mention. One that I'd highlight is in private lending, the second is net lease, and the third is SPACs.
Troy Gayeski: (16:09)
And, the private lending would mainly be the corporate entities?
Leslee Cowen: (16:13)
Corporate, real estate, all kinds, but in particular on the direct lending, we kind of bifurcated in our minds between middle market and larger scale. And on the middle market side, this has been our bread and butter since our inception in 2002. So, this has always been a core part of our investing practice. Well, one of the things that really carried over from the pandemic last year, during that time we were able to really expand our network of borrowers, and the reason why we were able to do that is because we were able to provide capital quickly, efficiently. We knew how to do it, we knew how to structure transactions, and we were able to be of service to all kinds of companies in their times of need. That loyalty has paid off, so it paid off during the pandemic, and it's now paying off now as well because we're actually finding that we're able to help provide capital to those same companies that are now focused on M&A and growth and restructuring or refinancing their balance sheets.
Leslee Cowen: (17:07)
The other one notable change that's happened during the course of this year that I think is also worth mentioning, and one that we're seeing and participating in is the larger scale transactions in the billion dollar range, and we're seeing the disintermediation of the commercial banks. Once upon a time, not too long ago, commercial banks were in charge of agenting and broadly syndicating such transactions, and what we're seeing now is an increase in transactions where a handful of lenders get together and provide a borrower with a single solution that the borrower is willing to do to pay a slightly higher coupon in exchange for certainty of closing, lack of flex in pricing, and efficiency. And so, that's a major trend that we're seeing this year post-pandemic.
Troy Gayeski: (18:00)
So Leslee, it's almost like it's back to the future for Fortress. You had your pandemic investing period where you killed it, and now it's back to the future doing what you were doing prior to the pandemic and given those opportunities, what type of returns are we talking about for investors? And, I don't think there's any compliance... Oh, I see a compliance person. Maybe you can't say anything, but give us a rough guide on what you think is realistic?
Leslee Cowen: (18:24)
Well, basically it all is a function of what you do unlevered versus levered. That's how it basically works. So on an unlevered basis, we're still talking about single digits kinds of returns, but based on the financing facilities that we've put together in our various funds, it allows us to generate returns that are in the mid to high teens and sometimes higher just as a function of, again, what our assets and liabilities are.
Troy Gayeski: (18:48)
So, I got to get my slide rule out for this, but I think mid to high teens is a little better than risk-free right now, just a tad bit. I have to go back to the old school calculator for that one, but Jason, so we were talking about this before and there's a narrative out there, obviously that there's no distress, 400 over, or not 400 over, 400 absolute for high yield, default rates have collapsed, but your point of view is that this is actually a great environment for a fund like yours because you can harvest a lot of the intellectual capital that you put in over the last six to 12 months. Can you kind of flip that narrative on its head for us, so we understand a little bit more what we're you talking about?
Jason Mudrick: (19:29)
Sure, and by the way, I love getting invited to talk on a panel about finding value in distress when credit spreads are at all time heights and the equity markets are at all time highs. I would talk to generally two themes. One, I would say macro versus micro, and two, trading versus investing. I think this is the point you're making about how you harvest these investments. So on the first, we're not a macro investor. Distressed is an asset class, it's not something that we would invest in ever. Even last year, it's a macro trade and it's not what we're good at. I think there's others that are very good at it. We're special situation investors with a focus on over leveraged capital structures. We're trying to find mispriced securities and I think overleveraged capital structures lend themselves very well to that for a variety of reasons. They're opaque, they're in transition, you need to have a very unique skillset, contract law, bankruptcy law, negotiating dynamics, management won't talk to you, they're illiquid.
Jason Mudrick: (20:29)
There's all these things, and many others that allow these situations to be fertile hunting grounds for a strategy like ours. So, if you told me, should I buy an index of distressed credit right now? This is the macro, I would say absolutely not. You want spreads to be wide, you want the distress ratio to be high, you want the default ratio to be high, and we have none of those three things now.
Troy Gayeski: (20:49)
So, a terrible beta environment basically.
Jason Mudrick: (20:51)
Yeah, I don't know that it will get tighter or who knows what's going to happen over the next year, but this is not a favorable risk reward for that asset class, but what we do have is a tremendous amount of overleveraged businesses. When you keep interest rates low for 12 years, companies borrow and coming out of great financial crisis, we had a little over a trillion of levered credit and it's close to 3 trillion now. And if you look at average debt to EBITDA multiples at new issue over the last five years, it's all over five times, and by the way, that's debt to adjusted EBITDA. There's a lot of very aggressive add-backs to get to an adjusted, but it's probably closer to six times.
Troy Gayeski: (21:25)
Jason, are you seeing the private equity guys play games with EBITDA? Are you suggesting that?
Jason Mudrick: (21:31)
Well interestingly, we give them credit for some add-backs and we don't give them credit for others. We call them recurring non-recurrings, but it's usually about half of what they're adding back is kind of BS and half is probably real, so probably five and a half to six times. So, big opportunity set, that's sort of the positive macro negative.
Jason Mudrick: (21:51)
And then to your point, trading versus investing. We're not buying things that are down 20 points hoping they go up 10 points, and we're trying to buy businesses through their debt. We're buying fulcrum debt securities underwriting to a default where we can convert that to equity and own the business cheaply, and you have to understand, that takes a long time. It's usually like a year to restructure the balance sheet. Then, the company is private and you own it, and now it's like a year or two where you start fixing it and putting new management teams in and sending them the right way and shedding businesses and buying businesses, then you go and exit. This is what a lot of people don't get when they think about distressed return streams. Oftentimes because of the way we're forced to market these situations, it's a big J curve.
Jason Mudrick: (22:33)
You're usually losing money when you're buying these things, and then you're doing all this stuff to optimize the business and nobody's giving you credit for it because it's not a quoted... It never trades, it trades by appointment, and guys are still quoting it from an analysis that's two years old because it's private, and a lot of the return is made when you go an exit. And to exit, you need healthy equity markets and healthy M&A markets because that's usually the exit. So, people will look at our return stream because we have this more private equity-like approach to distressed investing and they're like, "When I would've thought you guys would do really well, you'd do okay, and in years where there's nothing to do in distress, you guys kill it." And I'm like, "Yes, because we're selling things that we bought three or four years ago."
Jason Mudrick: (23:09)
And, that's a lot of what we're doing now, and what I think we'll expect that we'll do over the next 12 to 24 months not knowing what the market's going to throw at us, but a lot of things that we bought that we owned pre-COVID, that we sort of navigated through COVID, and also things that we bought during COVID, we'll be looking to exit and that will drive a lot of performance. So, it is somewhat counterintuitive with the approach that we take finding value in distress. A lot of times some of your best performance can be in years where you might think there's nothing to do in distress.
Troy Gayeski: (23:37)
And Jason, you don't have to be as specific as Leslee was. Thank you for the specificity on the return expectations, but in an environment like this, what type of returns do you think you can generate for investors?
Jason Mudrick: (23:47)
We're always trying to make 20.
Troy Gayeski: (23:49)
Net, right?
Jason Mudrick: (23:51)
20 net, yeah. Some of our funds have been successful with that and others are [crosstalk 00:23:57], but that's what we're targeting.
Troy Gayeski: (23:59)
So Todd.
Todd Lemkin: (24:00)
Yes.
Troy Gayeski: (24:01)
You're not asleep yet, are you? Sorry, it was a long time in between.
Todd Lemkin: (24:05)
[crosstalk 00:24:05].
Troy Gayeski: (24:05)
I saw you dozing off there. No, I'm just kidding. So, equity or credit.
Todd Lemkin: (24:11)
Right.
Troy Gayeski: (24:12)
In which sectors specifically do you think now offer the best value in your space?
Todd Lemkin: (24:20)
I think almost like Lee Cooperman said the other day, you see it really in credit, you see it in equities too. It's sort of all the other stuff. It's the value, it's the travel leisure, it's sort of the COVID hangover relics that I think you still find.
Troy Gayeski: (24:36)
There's still the catch-up trade.
Todd Lemkin: (24:38)
There's still the catch-up trade there. There's still a question mark about you take a credit like Travelport, which is software for the airlines to communicate with travel agents. There's still a big question mark about when does business travel come back, travel in Asia come back, et cetera. I think there are some [crosstalk 00:24:54]-
Troy Gayeski: (24:54)
In five years is the latest estimate right now.
Todd Lemkin: (24:57)
It moves around all the time.
Troy Gayeski: (24:58)
Obviously-
Todd Lemkin: (24:58)
It keeps getting extended and the businesses themselves keep adopting to this new environment as well, so you've got that going on real time also. I think there's very much the haves and have nots in this market, and I think in a way it all stems from asset management has become so slotted with verticals. You've got a lot of money in private credit, a lot of money in distressed, a lot of money chasing these very well-defined mandates, and what we've tried to look for as a multi-strat is really what's falling in between the cracks, in between those verticals.
Troy Gayeski: (25:33)
And, cutting across capital-
Todd Lemkin: (25:34)
And, cutting across capital structures. I think without leverage it's difficult to say you're going to generate 20% net in this environment, but I think you take some structured products, opportunities where we're getting 10, 12% total returns.
Troy Gayeski: (25:48)
Still?
Todd Lemkin: (25:48)
Yeah, I think you still are, and some interesting corporate credit opportunities, the Travelports of the world, or even the mall space, something like CBL, where there are opportunities to make 20 plus there because you're playing in a more fulcrum security, but it's a real upswing, cyclical upswing when and if we come out of this, and then there are some interesting things in real estate, there's a lot of interesting things in the capital solution, excuse me, part of the market special situations part of the market. We're working on a deal right now for a business outsourcing business sort of software, call centers, that kind of thing that just sort of overstayed its welcome on its capital structure.
Todd Lemkin: (26:26)
You see a lot of that where particularly the private companies, they miscalculated. They didn't obviously see this coming. Now, their capital structures are coming due in a year and a half, and they've got to pay up to get some short of short-term bridge-type financing and you can actually get high teens type total returns there unlevered. But again, I think it's needle in the haystack. You've got to be nimble and you've got to look across all these asset classes and really cherry pick them. I think it's challenging to be out there with this one dedicated mandate if you're not just going to find the market. There's just so much capital in the system.
Troy Gayeski: (26:59)
So, anything in commodity still, or have you faded that?
Todd Lemkin: (27:02)
We've pretty much faded it out. We still have some of our offshore drilling equity exposure. Most of them have restructured. I think that space, believe it or not, is actually pretty interesting right now.
Troy Gayeski: (27:13)
It's part of the catch-up theme, right?
Todd Lemkin: (27:14)
Very much the catch-up theme with these new capital structures and management teams are much more incentivized to act rationally, take non-performing boats out of the water, consolidation, not holding out to try to make money on equity options with all this leverage from the past. I think it's a little bit of a left for dead sector, which is interesting, but again, you're tied to oil prices, you're tied to the global economy. It should arguably be a very good environment for credit, stating the obvious and that, and that is why spreads and yields are where they are. But on the other hand, it's a very artificial feeling of stability. And so, we're also running hedges to this day against just sort of broader market indices, high yield as well as S&P on the theory that we're okay with the range of outcomes being here. We just don't want that [crosstalk 00:28:00] shock moment again. We want to hedge that out as much as we can.
Troy Gayeski: (28:05)
So, what do you think that leads to for investors' net of fees?
Todd Lemkin: (28:08)
I think you can get to kind of, again, we're running unlevered, so more like low teens type of return.
Troy Gayeski: (28:14)
12 to 15?
Todd Lemkin: (28:15)
Yeah, I think you can.
Troy Gayeski: (28:18)
Thank you. So, to segue to you, Peter, really quick, we've been talking a lot about corporate capital structures, but one of the focuses at Sculptor that many of you may be unaware of is they have a very healthy convertible bond exposure and they run convertible arbitrage. They've also been very active in the SPAC market and yes, not every SPAC is bad. I think we can all hopefully agree on that. And then lastly, you've been buying more convexity recently, so I know those are three different topics, so you can touch upon the opportunity in converts, convert ARB, SPACs and talk about how excited you are to buy downside protection as cheaply as you've done in quite some time.
Peter Wallach: (28:55)
Sure. Thanks, Troy. Now, the first thing is knowing what ballpark you're playing in, which is I think a pretty common aphorism, and what you said is first and second derivative of growth is slowing. The second derivative of global stimulus is slowing. And so, some of the places that we're interested in looking are places that are, one, potentially uncorrelated to just direction in the market to whether it's credit equity, et cetera. Another is another fear in a common potential tripping point. It could be the reemergence of inflation and an inflection point in monetary policy here and elsewhere, so a couple of the places that you touched on. So, first with convertible bonds and we like convertible bonds and SPACs for different reasons. The convertible bond market right now, and particularly in Asia, has very interesting pockets of cheapness that are in some cases rarely seen and convertible bonds broadly are a type of asset.
Peter Wallach: (29:57)
It's a very big asset class that hasn't recovered nearly to its pre-pandemic level, and then also on a relative basis, relative to where credit and equities are trading, it looks even more attractive. And so with Asia, you have a constellation of factors of regulatory, a lot of exogenous factors, whether it's regulatory, trade, and sometimes liquidity and access to markets that we've been able to bridge. And, we're seeing types of convertible bonds that are trading multiple hundreds of basis points cheap to where they were trading pre-pandemic, and on an absolute basis, you can get mid-single digits unlevered of cheapness, and then way the way we do it in convertible bonds is we hedge the equity, we hedge the credit, we can hedge duration, we hedge to term, we have some locked in term financing.
Peter Wallach: (30:48)
And, what we were able to do is on an unlevered basis, mid high singles in some areas, which obviously levers to well into the teens for a non-directional exposure. So, an interesting way to play Asia right now, or some parts of China in greater China for that reason. Now on SPACs, obviously for a different reason, we've been involved in the SPAC market in various forms for the last couple of decades, so not just over the last 18 or 24 months, and we've seen periods of euphoria like Q1 2021. We've seen periods of despair and uncertainty somewhat like the summer of 2021 and October of last year and everything in between. And, what's interesting about that market right now is the ability to invest at several hundred basis points cheap to the cash in the trust. So, you could buy cash in the trust at call it close to 3% discount.
Peter Wallach: (31:45)
And, then with conservative leverage and very little term and very little duration, you can access high singles, low double digits, and in a market where some people are doing that instead of potentially a cash investment, and there are so many ways that you were getting some free options, you can have early business combinations as opposed to the one or two years that are expected, you could have a positive response in the public markets for a type of company that the business combines with, and then there's more and more negotiations that are ongoing and I don't think this is a secret of sponsor economics can certainly be transferred in some instances, given the supply demand imbalance. There's 130 billion of SPACs out there that are looking for businesses to combine with. There's 30 or 40 billion that have announced, but not yet completed.
Peter Wallach: (32:34)
And, a lot of these are trading at a discount. So, I think that is a very interesting short duration, uncorrelated, non-directional way to play right now, and certainly as part of one of the building blocks of our multi-strategy funds. And, that last point that you mentioned as far as always protecting the left tail, it's a building block. It's part of our social contract with investors and it's part of our value proposition, and one of the ways we do this is through sourcing cheap volatility. If I told you that the last 30 days S&P vol is eight and the last five days is four, and you're able to buy implied protection on that for not much more than what it's realized, I think that people might be surprised of the relative bargain.
Peter Wallach: (33:16)
So there are certain structures that we employ, sometimes it's synthetic puts, sometimes it's others where basically allows you to buy cheap volatility, and then when the flood comes, once again, you're not a forced seller, you're able to monetize the hedges and play off them. So, that's one of the ways that we've used that as a complement to our sort of broad strokes investment program.
Troy Gayeski: (33:38)
Great, and along those lines, Todd, what do you think the biggest risk to markets and your strategies right now? Is it as simple as Fed monetary policy shift, or marginal tax rates going up to 60% plus in New York City, or what would you pen it as?
Todd Lemkin: (33:53)
I think those are all on the list and you've got to obviously put the pandemic on the list as well, the virus itself on the list. I think it's, again, at the end of the day, the evaluations and the equity markets reflect a lot of optimism about growth for the future. Next year will be obviously a more challenging year to generate those comps year over year. If you spice that up with a little Fed restraint tapering going on, you could definitely see something maybe reminiscent of what we saw in '15 where you just get a pulling back general breaking-
Troy Gayeski: (34:28)
A sloppy, messy environment [crosstalk 00:34:30]-
Todd Lemkin: (34:29)
Which has ripple effect.
Troy Gayeski: (34:32)
Are you ramping up your hedges now?
Todd Lemkin: (34:33)
We have been, yeah. And, what we're trying to do really is take chips off the table, and we've been looking for opportunities to monetize positions like Jason was touching on. We have been trying to keep our investing very short-term with a lot of endogenous liquidity under the theory that if we can get that money back we can play offense in a more interesting environment.
Troy Gayeski: (34:54)
[crosstalk 00:34:54].
Todd Lemkin: (34:55)
And, trying to stay higher in the capital structure, but you never really see what that magic moment is.
Troy Gayeski: (35:03)
We only have a couple more seconds, so Leslee, are you guys getting more defensive now or are you just sailing through?
Leslee Cowen: (35:09)
We are defensive, but our whole DNA is basically defensive, and so one of the things we do, we try to stay at the top of the capital structure. We have largely a variable rate portfolio, so we're not taking a lot of interest rate risk, and we look for a lot of idiosyncratic and uncorrelated risks and opportunities that are not market-driven.