Invest Like the Best with Patrick O'Shaughnessy - Kieran Goodwin - Imagination, Volatility, and the Pursuit of Alpha - [Invest Like the Best, EP.331]

Starting point is 00:00:02 Hello and welcome, everyone. I'm Patrick O'Shaughnessy, and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, stories, and strategies that will help you better invest both your time and your money. Invest like the best is part of the Colossus family of podcasts, and you can access all our podcasts, including edited transcripts, show notes, and other resources to keep learning at join colossus.com. Patrick O'Shaughnessy is the CEO and founding partner of Positive Sum and the CEO. of O'Shaughnessy asset management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of positive sum or O'Shaunacy asset management. This podcast is for informational purposes only and should not be relied upon as a basis

Starting point is 00:00:48 for investment decisions. Clients of positive sum or O'Shaunicee asset management may maintain positions in the securities discussed in this podcast. My guest today is Kieran Goodwin. Kieran spent over two decades at the frontier of Krati, credit investing. During the global financial crisis, he was a partner and head of trading at King Street Capital, which grew from $4 billion to $20 billion while he was there. He then left to start his own credit hedge fund panning capital management. In our discussion, we cover the state of private credit

Starting point is 00:01:19 today, which forms of alpha he's most skeptical of, and the blend of EQ and IQ necessary for success in investing. Please enjoy my conversation with Kieran Goodwin. So maybe a fun place to begin is with the world of private. credit. We talked a lot about it already today at lunch, but I think your take on it is especially interesting. Can you just give what you view as the state of the union of private credit today in capital markets and why you find it interesting as just a category to consider? The growth of private credit, you kind of have to start the conversation there. I mean, you had this asset class that was somewhat of a cottage industry around the time of the great financial crisis. And

Starting point is 00:02:04 confluence events happened, probably the most important is that rates went to zero. So there was a search for yield that benefited spread product wherever. But then also you had the Fed OCC rules where banks could not lend to companies greater than six times EBTA. So with private equity looking for debt to finance capital structures, private credit was a solution in a sense. And then as private credit equity had more and more dry powder. The results were doing well. That was more to ban for private credit. So you just had an explosion of growth and this contraption set up of more private equity, more private credit, but still with zero percent as so for a libel or a labor time now so far and spreads being 550 to 600, you're getting 6 percent, the funds needed

Starting point is 00:02:58 to lever themselves to get to eight, nine percent. If you're an alternative asset manager and you're coming to an LP and saying, I can give you five, six percent. No one cares. It's got to be like at least high single digits. And what the allocators loved was there's no volatility. Jason's Wyaggett Wall Street Journal wrote a great article talking about our Cliffwater, who's not only consultant, but also in private credit, put out on a fund, a 10-sharp ratio. He interviewed Professor Sharp. I can't remember his first name. And Professor Sharp was like, that's ridiculous. Obviously, and they pulled it from it. But that's the world we're living in where like there's this ultimate sharp ratios and everyone's like there's no vol and like of course

Starting point is 00:03:37 there's vol there's vol that anything your car leaves the lot and it's down 30 percent there's volatility it's just you're not marking it to market so the difference between volatility of what an asset's worth and actually marking it is different so you've had this explosion and now we have rates much higher so you have these loans that are five to seven year loans loans made in 2019 you know 2021 the companies thought they were going to pay five and a half six percent interest on and now those are 11% interest loans. And if you think about the typical private equity middle market company, they were bought it 12 times, EBDA, they put seven turns of leverage on it.

Starting point is 00:04:16 And seven turns of leverage only allows if you use all your EBITA, you can pay 14.28 or so whatever percent interest. So now you're paying 11, where you were paying six, there's a lot less room for error right now. And we haven't seen that interest really flow through because, like, these rates haven't so fast and furious that even Q1 of last year, like, rates were really, really low. So I think going forward, you're seeing a lot more stress on these companies, you're going to have more defaults. Like defaults are picking up. Some bad trades were done. Private equity as an asset class has been around for 40 odd years. And sometimes excess gets in the system. We saw it with the massive LVOs before the

Starting point is 00:04:58 great financial crisis, I would say there's probably more excess in private equity in the middle market space than anywhere else and direct lenders. So when we say private credit, I'm really speaking about direct lending, particularly to middle market private equity sponsored companies. I don't think it's unnatural to think that you're going to have more defaults in the sub-100 million dollar EBITA space, then you are in necessarily S&P companies. You've dealt with a lot of GPs, LPs, you've been both. Talk about this notion of ball washing, the concept itself and why it's an important thing to think about and understand from the allocator's perspective, from the GP's perspective,

Starting point is 00:05:38 from the end customer, the asset owner's perspective. It's just like it's like a neat, interesting concept. You think about institutional allocation to alternative asset management. We'll start with someone like David Swenson, who was. the godfather in a sense of thinking about that alternative assets should be in any big institutional portfolio given that you have a longer time horizon. Well, you have competition. When David Spencer first started, he was probably the chief bottle washer and was looking, you know, meeting private equity guys, meeting hedge fund, real asset managers. And now within a place like Yale or any other

Starting point is 00:06:12 place, they have teams. They have the private credit team, private equity team, hedge fund team, infrastructure, and all of those individuals are competing to get more assets in the portfolio, because that's how they ascend and maybe become the CIO. So when you have your monthly meeting or quarterly meeting and you're looking at returns, and you're the long short equity hedge fund allocator, and you've got volatility everywhere versus you're the private credit allocator, and you're like, yeah, we're doing our 10% annualized, Every month, it's 80, 90 basis points, checks in the mail. That's like a pretty powerful position in the last few years.

Starting point is 00:06:55 So, yeah, I've done 500 meetings as a GP, and there are a few allocators that really embrace volatility. They would rather have, let's call it, an ARB strategy that's 15%, which, I mean, so would I. Think about it. If you could make 15% forever with no volatility, like, sounds pretty good. Yeah, who wouldn't sign up for that? But the reality is that when you're in a business cycle and the faults are picking up, you would think, and we're seeing in the high yield markets, we're seeing the levered loan markets, prices are going down. We're not seeing in the private credit markets because there's no observable secondary trading of loans. Talk about what you think could be the domino or domino effects here, because the whole idea behind volwashing is a lot of this stuff happens very slowly.

Starting point is 00:07:42 Unlike something like Silicon Valley Bank or something that publicly traded equity marks all over the place, you know what's going on. Seems fine until it's not. And then it can go poof really quickly. What is like the worst case scenario you could envision for how what I'll call like bad private credit loans go wrong and get worked out in the market? I'm just pointing out a possibility. What could happen is given that to achieve eight, nine, 10, 11 percent net to investors, If you were involved as a GP, if you were in a direct lending market, you were making loans at Sofer plus 600, you had to have leverage at the fund level. So you went to a Goldman Sachs, city, JP, all the big banks, I'm going to lever this fund one to one. So if I have a billion dollar fund, I'm going to make two billion of loans.

Starting point is 00:08:34 I'm going to borrow a billion. And they would give you a line of financing. And that line has covenants. and the mark-to-market of the loans, you're required to go to a third-party valuation provider that gives you a mark. Most of those marks are going to be par all the time. That's part of the vol-washing in a sense. There's arguments we made for or against that.

Starting point is 00:08:58 We don't necessarily have to go there. But defaults are real. That's the nature of credit. When principal comes due, you pay me or don't. And, yeah, we can do amendments. what have you, but end of the day, it's not performing as the faults pick up, which we've seen in Q1, and again, I think it's going to be in the lower end of the market is going to have a bigger percentage of faults than the higher end of the market. If that trend does continue,

Starting point is 00:09:23 you're going to see some of the worst performing portfolios of all of private credit. Their lines are going to get cut. And the leverage providers, the banks, the sell side, is going to say, you need to start paying us down this line. And if the lines, they don't have loans coming due to pay off, they're going to have to sell loans in the secondary market. Many of these direct lending loans are bilateral in nature, meaning it's just the lender and the borrower. So there's no public information. So just the process of selling a loan as the GP, you're going to have to tell you to borrow, like, listen, I'm going to take this private information, give it to a third party to evaluate the loan to see if I can sell it. That's going to be

Starting point is 00:10:08 cumbersome. As we see when Wall Street is financing positions, whether it's listed equities or hedge fund stakes, whatever it is, warehousing lines, they're pretty good about getting paid back. I mean, outside of the Credit Suisse situation, Wall Street, the lenders have a very good track record. If one of the years or two of these situations happen, all the other banks will know this is happening and they're going to start, okay, who are our worst performers? Which ones are we worried? about. Let's have conversations. The correlation of, hey, this is not an issue and they're going to be able to pay us back. That goes from like nobody has a problem to like there's a lot of problems really quickly. The billion dollars in your example that's debt capital from J.P. Morgan or something to the

Starting point is 00:10:57 fund. Talk a bit about like the origin of that piece. Why is J.P. Morgan in that business? What got us to there where that amount of borrowing was possible at the fund level, assuming that, like if something like this were to happen, new lending will probably dry up too. I've heard anecdotally that's much harder to get today. It is. Just because of rising rates. I just feel like maybe the system is getting a sense that up against the natural limit. Right, right.

Starting point is 00:11:23 We wanted to do X billion of that and we've kind of hit our limit. As we've seen, private credit keeps growing and more funds are out every day trying to raise more money. There's a natural limit of that, which I think is the Fed report, I think it was about a couple hundred billion dollars of direct loans of lending by banks to funds so how did we get here the fund would just say like hey listen i'm going to raise a billion i'm only going to lever it one time so you have 50% cushion on these loans which are all first lien loans that would have again 50% cushion so let's just do diversity of the loan pool and what would have to happen and so if they're earning libra plus 550 600

Starting point is 00:12:06 then the bank who's going to lend the fund money is saying, well, if I lend it live at $2.50,300, that's a pretty good deal for me because I'm top of the stack of a first lien position anyway with diversity. And I think this GP knows how to make good loans. I have a relationship, what have you. If you think about where we were with 0% rates and deposits, a place like JPMorgan, Bank of America, Goldman Sachs, they were taking in money at zero, and now they're lending it out Liar Plus 250, 300,

Starting point is 00:12:39 and even LIB was 1%, 2%, but now their deposit basis is probably getting a little more competitive as well. So it's like, is this loan that they're making as good a business in a sense? There's a related lesson here from, I think you call it the worst trade you've made. Can you tell that story and then we'll talk about the lesson? Yeah, thanks for bringing that up. Yeah, so back in the summer of 2002, I was trading prime. at UBS, and I had a position in WorldCom, I owned bonds that matured in early 2003, and they were trading 80 cents in the dollar, and the other debt of WorldCom was trading decently lower

Starting point is 00:13:17 the further maturities. And one of the reasons that I bought this bond was because they had a revolver that was, let's say, June of 2003. So they had an undrawn revolver, which they could have drew from the bank, $500 million, and easily paid off this maturity. So the only way that you could get crushed on this position, and I was short a bunch of other, this is my long, this is going to pay for my short. I was actually overall bearish at the time. This was the smart long to have. The only way you could get crushed was fraud.

Starting point is 00:13:49 I was like, what are they doing here? And what happened? Fraud. Fraud happened. So I got crushed. It's good to know what's going to kill you and it kills you. It still hurts, even if you've got to understand that. What was the fraud of WorldCom? Really, at the end of the day, Bernie Evers went to jail.

Starting point is 00:14:04 The fraud was WorldCom was capitalizing operating expenses. We had this early 2000s, fiber, everything's getting put in the ground, massive growth still, even though there was a consolidation, like the level three's and the global crossings went down. WorldCom and AT&T were still growing. In 18Ts, EBITs, EBITO margins were 30%, 28%, and WorldComs were like 42%. And AT&T, like, guys were getting fired because they couldn't keep up with WorldCom. WorldCom was just taking regular expenses that were operating expenses. They were putting them below the line as capital expenses, so their operating margins looked a lot better. So the point I was making, like, that was 21 years ago.

Starting point is 00:14:48 When you're thinking about the explosion of middle market private equity, I mean, absolute explosion in the last 15 years, there's got to be some of that. I play golf a little bit. someone's like, what did you shoot? Like, a 90? I shot a 90. Was it a hard 90 or a soft 90? Like, it's a big difference.

Starting point is 00:15:07 I'll just give me a triple there kind of thing. Hard numbers and soft numbers are much different. And I feel like in the world of EBITA, there is this notion of hard and soft. And in a good market, soft is okay. But in a tougher market, everyone wants hard numbers. How do you think this plays out? Like, if you had to handicap it, what do you think happens in the world of private credit in the next three years or something like that? Well, I mean, let's just say in the

Starting point is 00:15:34 large numbers, the amount of growth that we've had in the asset class has been astounding. It's gone from $250 billion in 2010 to $1.4 trillion. If I take a step back, I think the asset cast will keep growing. If I have to handicap it, I think there's going to be a consolidation and it's going to be a shakeout. And probably the bigger players benefit from that shakeout like we've seen in every other alternative asset class in a sense. Describe what you mean there in terms of the cycle that happens there where the bigger players ultimately benefit? Well, if you have thousands of managers.

Starting point is 00:16:10 Which there are, 2,000 or something. Yeah, yeah, thousands of managers. I just don't think the talent is evenly distributed and there's going to be, I'm not saying who it is, but like it's going to be some funds that just go away, just like we'll see in venture, just like we'll see in middle market private equity. but that process of them getting blown out might cause a hiccup for a bit in the market in general. Institution allocators are like, wait, I'm not always going to get 9% back. I could get 70 cents on the dollar back.

Starting point is 00:16:40 It's not going to be zeros like you could in venture. You could literally give your money and get back nothing in a venture fund. But it's going to be super disappointing, potentially super disappointing on the margin, which I think will pause. and then the bigger firms that have more resources and probably deeper relationships are going to see, like, this cleanup trade is a pretty fat pitch, and we should lean in when the market really needs capital, which I'm not one to think about. You always see here like these funding cliffs, like, oh, so much commercial real estate, all this is due. And like, I've heard this always, high yield in market next year, there's so much due. Like, there's always a lot of maturity's due.

Starting point is 00:17:21 If you get a market where all of a sudden there's a pause a bit, there's a decent amount of dry powder in private credit as well. Pricing can't really change that much. Sofer's at 5%. And leverage is probably down from normal middle market company would be 12 times. EBDA they're lending at seven. Maybe they're lending five and a half turns now. But it's still sofer plus 6%. Again, there's limits on how much interest you can't pay 15%.

Starting point is 00:17:48 It just doesn't work for almost any company. If you can pay 15%, you don't need debt in a sense. You're a good enough business that you should just raise equity. What do you think of the world of venture right now? I know you thought about it a little bit and met some people that do that style of investing and understand the setup. What do you think of that space? I mean, again, much like private credit, it was a cottage.

Starting point is 00:18:11 I mean, there were some big players, A16Z and Sequoia and a bunch of others that massive established players, but there were a lot of small firms in venture at the time. of the financial crisis, and that a ton of growth. And then there's been so many two people starting a firm with $50, 100 million, there's just hundreds and hundreds of those kind of firms. I'd say the barrier to entry, as far as alternative asset managers, the lowest has been in venture. You just don't need the SEC registration and prime brokerage and the bank relationships, and it's much easier to set up two people. You and I, let's do a fund. We raise $13 million. dollars. Really hard to do in private equity. No one cares in private credit. Hedge funds, the fixed

Starting point is 00:18:55 costs, you used to be able to do it. Now you can't really do it. So I think the smaller managers are going to get blown up and you're going to have a shakeout. We hear about all the time with respects to institutional allocators, they have a denominator effect. They've put out more money and drawdown vehicles, whether it's private equity, private credit, real estate or venture. They were getting capital backed them so quickly on wins. They're like, all right, let's make a bigger allocation. And now their capital is not only, do they put out more than they think they're going to have, but it's getting drawn quicker. And now there's going to be a pullback like, wait, let's look at how we didn't venture. And actually, most of our money was made with one out of our 15 managers.

Starting point is 00:19:40 I think there's going to be a natural consolidation. If you think back across your entire investing career. Can you paint the picture of the time that you felt you were at the peak of your powers? Yes. Yeah, clearly. I had a massive advantage, which right time, right place, you catch the right wave. I'm a big believer that it's more important to be on the right wave than necessarily be the best surfer. The wave is more important. And I started in creditors in 1995, almost by default. I was trading interest trade options and move firms. We have a seed for you. It's credit derivatives.

Starting point is 00:20:17 So that means for the first three years, I just talked to myself. I mean, I had credit derivative trade around my car, business card. No one knew what it was. No one would give me the time of day. It was good to think about the markets and optionality and credit markets and how this product would potentially fit in, the use case for it. So then the market picked up as soon as the Asian crisis happened and then long-term capital and Russia. and then you had Y2K and the tech meltdown and obviously 9-11, Enron, WorldCom. So like from 97-02, super volatile time, really high volatility in the equity markets,

Starting point is 00:20:51 but also in the credit markets, really, really high volatility, which is one of the reasons like convert hedge funds did so well. They had amazingly high equity volatility that they were hedging against, and then the credit spreads were wide. They had like kind of the best of both worlds. So then I'd traded prop for a couple of years. When I was trading prop, because I'd started, the credit derivative market, like, I almost knew every trade that was happening. I kind of knew

Starting point is 00:21:13 why every trade was happening. Starting in a market and seeing it grow up, getting a sense of, like, knowing what every market move, every price that happened, you get like a sense of calm almost. Nothing's surprising. And understanding the origin. So going into 2008, it was way worse than I ever thought it was going to be, I felt that I was as good as I could be at that time. We had a great team, and yeah, I was at Kingshree at the time. Fran Biondi, who taught me a ton about distress investing, credit investing. We had like two circles. I had this kind of derivative, optionality, new product background. He had deep value. The intersection, when those two circles kind of intersected, that sliver, we felt like we had a big advantage that we were seeing

Starting point is 00:22:07 the markets from two different angles that most people weren't. That's the period, that 0607 period, when the world of subprime was blowing up and commercial real estate was blowing up and all these LBOs were like, how are you going to fund these LBOs? And we were really, really sure that they were going to get hung and that there was going to be contagion. We were super confident on our view. Can you explain the psychology of being very successful?

Starting point is 00:22:37 in the hedge fund career or profession, what it's like to go from learning something, being new at something, to making a ton of money in a fairly like virtual job. Like you're not making a widget. You're sort of like a symbol manipulator. And then all of a sudden you have a lot of money. What is that experience like? I'm going to use probably a terrible word because my vocabulary isn't as good as yours. It's surreal.

Starting point is 00:23:03 It's out of body in a sense. overnight successes are 10 years in the making. Rarely do you have someone that just steps in on day one. Most of the time, I would say, whether it's private equity or hedge fund, during your 20s, you're kind of learning a craft. And then if you're lucky, you get some insights that maybe are unique. There's an assumed narrative out there that you're like, I don't believe in this. Everyone's believing this.

Starting point is 00:23:32 I don't think this is true. and the payout, if I'm right, betting against that, is massive. And then if you're really lucky, you get in a seat where you have real leverage to be in a situation, and then you need it to happen. So there's like a confluence event. So there's definitely some luck involved in that. When it all does happen, it can happen really quickly. And there's like, what now?

Starting point is 00:23:57 How do I follow it up? Yeah, what's my next album, right? You think about like bands, and this is not a lot. a unique thought, but like, I remember in college, I'm old, blues travelers came to Duke a bunch, and they released their album, and it was, like, awesome. And then they released the second album was awesome. They didn't work in on those songs for like seven or eight years. And then they released their third album. It's like, it kind of sucks because like they only had like eight months. This is all I got, right? It's like the first book for an author, same phenomenon. Yeah,

Starting point is 00:24:27 that phenomenon. It's like, all right, what's the follow up? So in any kind of investing, like I'm always amazed in awe of the investors that can change stripes and be fluid over decades of just figuring out how to make money. It's kind of sobering when someone like Stan Drucker-Miller, I'd listen at the Sone conference. And he's always like, listen, you know, it's harder now because every time we were getting into a recession, I knew the Fed was going to have to cut rates, and I would just buy the two-year note. I can't do that this time. This time is different. And someone like him who's on anyone's all-time great list, when he says it, like, there's no magic formula. It's a puzzle that every day you have to go home a little defeated.

Starting point is 00:25:12 With the benefit of a lot of perspective, and you and I've always talked about lots of different kinds of investing, what kind of alpha do you believe exists or can exist? And what kinds of alpha are you skeptical of? Well, the skeptical is easier. I just think information, right, that was massive alpha over time. So if you think about the stressed. There was a real alpha in knowing, understanding the process, the bankruptcy, chapter 11, the court proceedings, filings that had to be made, reading those filings. And then there's an osmosis that happens where there's some firms that are really good at it. Some people leave those firms start their own firms. So understanding the process, that alpha gets dissipated. But then,

Starting point is 00:25:54 like, reorg research comes out, which that just completely flattened the playing field. So the process of bankruptcy, I mean, yes, there's twists on it. it and turns on it. And you think about the same thing with long short equity. I don't really understand how going quarter to quarter is there any alpha anymore. I think there was alpha at some point. I think that informational edge in any market over time, where is there alpha? I do believe there's alpha in time. And I believe there's alpha in the permanence of your capital. Going back to Buffett, his big advantage is he had time and permanence of capital. I definitely think there's alpha there. I think there's alpha in understanding new technology, whether it's biotech or AI or

Starting point is 00:26:40 blockchain, but then you always have to find a new new thing. Doesn't persist. But being on the edge, there's definitely alpha. If you're advising then, I don't even know who to put in the hypothetical here, a student, someone that's interested in investing, a pension manager, like whoever, a lot of people invest. Is the right average advice just put it in a Vanguard fund, do you think? Or should anyone and if so who, endeavor to do more than that. I don't believe in passive income. I do think there's alpha, like, you want to be a hustler, and you want to own real estate and be on your rent,

Starting point is 00:27:15 and you can do it on the side, or you have a buddy that you trust, that you can empower. I think there's a decent amount of alpha in small, medium businesses, and being more efficient. I'm a big fan of Blackstone. I think many of the massive alternative asset managers have a tremendous amount of talent at them. I just happen to know a bunch of people at Blackstone better

Starting point is 00:27:36 and for their real estate funds. Regardless what we think about real estate, like we were talking about before, like I think they have the best network. They source better than anyone else. They understand all aspects of the market. They are seeing it on the private equity side, what real estate trends are.

Starting point is 00:27:53 There's synergies there. If you had an allocation to Blackstone in real estate, that's a pretty good place to be. Speaking of Alpha, What do you think of income share agreements? I'm a big fan of income sharing agreements. I do think that we hear every day a problem with our economy is over levered, whether it's the public, private, the Western society, and the whole world is over levered.

Starting point is 00:28:17 I mean, you think about the Bitcoin maximalist, so much leverage, fiat. It really comes back to the fact that there is debt. If we had zero percent debt to GDP, the Bitcoin maximalist wouldn't really have a great argument. If all the dollars were backed by gold, what would their argument be? So it comes to debt. So how do you finance a venture, a person, an entity without debt? Well, equity. That's the other side of it. So that's the way I view income sharing agreements is that if you're a person has some talent or ambition or idea and you're willing to give up some percentage of your upside, it shouldn't be too much, it shouldn't be more than probably 10 or 15 percent. So it's not like you're like,

Starting point is 00:29:06 I can't believe I'm working for somebody else. Then I think equity financing is a great way to capitalize a talented person. And what does the equity finance get them? Well, it gets them resources now that would enable them to best use their talents and get training. Someone like an athlete, you get training, you get better nutrition, you get better sleep. if it's a YouTube personality, you get better microphones, you get better people working with you. If it's a DJ, you get a marketing firm, whatever it is, could be an engineer coming out of MIT. I just don't want any student loans. I don't want to think about that.

Starting point is 00:29:47 I want a place to live. I want to help my parents out. I just want a piece of mind that I can perform better. Why do you think there aren't more of these? All that makes sense to me. And I think a lot of people, obviously, like, the more capital there was here, the more efficiently priced stuff would get. The MIT CS grad or something would probably have a pretty nice nut that they could sell 10% of their or whatever it is. So why isn't there more of this?

Starting point is 00:30:14 It's an idea that's been bantied about quite a bit for five, six years now, but it doesn't seem like there's any critical mass. Why not? I think some of the areas it was first tried were the coding schools. and I don't think that was the right... Lambda, et cetera, yeah. I don't think that was the right cohort of individuals. I think it's best first tried on like whatever the field is, the top 1% talent,

Starting point is 00:30:38 where you have the chance to have an outlier that really outperforms. So it could be computer science majors at MIT, and it could be minor league baseball players, or it could be YouTube personalities that have hit certain metrics are already in like, are they going to be the next Mr. Beast? I think investors need to see a chance for the 100x on some portion of the portfolio. And it's a capital market. It's a new market. So there's a demand for capital from the individuals and the providers of capital, they haven't gotten return. I think all the deals have been done have been not that great. And then there's also

Starting point is 00:31:19 an education side to it, whereas if I know Purdue University had Mitch Daniels was a big proponent of it. Maybe like the 18, 19, 20-year-olds didn't really understand what they were signing up for. Not that they understand what they're signing up for when they're taking student loans. So I do think there's an education side of it. But starting with the outperformers, the real chance for the right-tail risk is critical. If you think about right-tail risk in investing organizations and you were backing, let's say you're investing money in a GP, and you got to like build the CIO like you would build like a Madden character

Starting point is 00:31:55 or something and you get 100 EQ points and 100 IQ points just generically how would you allocate those if you were trying to achieve most investment firm success? I'm assuming the IQ is like at a certain level like if I give him 100 EQ points

Starting point is 00:32:10 he's not going to be a zero IQ. Yeah let's say we start at the average right at 110 or whatever. I think it's more EQ than IQ but I think the EQ there has to be like a humble aspect of the EQ, which I think is a part of EQ is like knowing when to be humble. Being comfortable with hiring people that may be much smarter than you, but you feel like you can still add to their experience. You can still help them. You can still

Starting point is 00:32:38 help them achieve their maximal potential as investors. I think that's a big part of EQ, that coaching, managing aspect of a group of individuals, which, yeah, most of, whether it's a hedge fund or there's more IQ probably than EQ. Yeah. If you think about your reference class, like you happen to know a lot of the very successful leading investors of the generation or whatever, do you think that that's true, that those people on average have very high EQs? There's definitely exceptions.

Starting point is 00:33:11 Some of the investors that I've met that do. don't necessarily have high EQs with respect to relating to others. They have a sense of calm where they're very capable of not being influenced by others, which might not be great for a team. They might not give you great feedback, whether Soros said, like, his back hurt and he was to sell, like, they're not afraid to like come in and sell everything or say no. If they don't have a really good EQ, they've got like a strong sense of their independence, which it's hard not to get influenced because, yeah, you're at an organization. And like, even though it's like professional, don't take it personally, it's business, everyone takes everything a little personally.

Starting point is 00:33:59 If you're a PM and you have someone that you work with has done really good work and come with great ideas and I think that idea is stupid. It's hard to tell them all the time that. You can either be really, really gifted as giving messages, which is high EQ, or you can, like, I don't really care. And like, that's just the way I am. What do you think of with the current setup, the world of investing are capital markets careers as something that really talented people should go and do? Do you think that right now is a good time, if you're a smart, soon-to-be Duke grad or MIT grad or whatever it is, to go into the field of capital markets? or do you think that that talent should go into biotech or somewhere else? It's easy for me to say, like, oh, you shouldn't go in. You should try to make the world a better place, somewhat self-serving.

Starting point is 00:34:47 I think there's a tremendous amount of change. I think you have to go in wide open and be like, where's the change going to take place in the capital markets? I'm a big proponent of the blockchain. I have no prediction on the price of Bitcoin or Ethereum or any other, but I do think the blockchain will help solve some problems we have. it's hard to move money around the world. So global payment system is built on 40, 50-year-old rails. And settlement risk and counterparty risk is real in every kind of, whether it's a listed market or over-the-counter market,

Starting point is 00:35:20 where the blockchain can solve that problem as well. I'm not saying it's happening tomorrow. So I think if you're going into the capital market, it's like how do you solve problems? The blockchain can help. What's AI going to do? Well, it's going to do a lot. So if you are thinking about how does AI change capital markets,

Starting point is 00:35:35 how does it change investing, how's it change, how capital gets allocated, what the debt structures look like, does AI help on credit? Credit's hard. At some level, credit is all about belief. Do I believe I'm going to give you, I'm going to pay, do you believe that I'll pay you back? There's ability to pay and willingness to pay. And we saw that during the subprime debacle is that if a creditor was like, you have the money and the debtor was like, well, I don't need to pay you because I'm not getting kicked out of the house, the willingness to pay went way down. Even that with institutions, if you're a bad actor in the capital markets, it's harder to borrow money the next time. The companies or entities that pay back and are fair, they're more creditworthy.

Starting point is 00:36:21 I guess it goes a little beyond numbers in a sense. If you were teaching like a college course or maybe a graduate level course on credit investing specifically, what would be like the most major sections that you think would be teachable and important to learn for someone that wanted to do that style of investing? The best credit analysts that I've seen really understand cash flow and can raise a flag like, wait, this doesn't make sense. Why doesn't even on cash flow tie out? Why is this explanation taking 17 different footnotes to follow and why do I have to go around and amaze to see where the numbers are? I mean, I think accounting is really, really important. Then I think it's about optionality, which I think I'm very good at, is understanding optionality

Starting point is 00:37:06 in the sense that asset values change over time. You have a capital structure today. You have a company that has $100 million of EBITA and the market says it's worth 10 times. And that's a billion dollar company. And some private credit firm will lend you five times. They'll lend you 50% loan to value. So you have $500 million of debt, $500 million of equity. on a billion dollar company.

Starting point is 00:37:33 Well, we all know like asset values change over time. What is causing those assets to go up or down? Your customers, the margins, the supply chain, cost of labor. There's all these different factors. And the great credit worthy companies or entities like the US government, what have you, they have a lower volatility. And like understanding business and why do you have an 80% gross margin? And is that sustainable?

Starting point is 00:38:00 And why do you have a 45% EBITOM margin? And is that sustainable? Why is the 15% EBITR margin actually really sustainable, where there is a real moat there? Those questions and understanding volatility around the numbers, it's not static. It's always moving. And debt is forever. So everyone looks at like, oh, their credit where they borrowed money, they're rated. We know the rating agencies are behind.

Starting point is 00:38:22 If you're waiting for a rating agency to tell you that it's a less credit, obviously in private credit, there's no ratings whatsoever. So you just only have to be paranoid as a credit investor. What can change? What can put me where I don't have that cushion where I'm actually an equity? What about something similar question around volatility specifically, given that something obviously you've spent a crazy amount of time thinking about and working within. What do people underestimate about the power of volatility or not understand well enough

Starting point is 00:38:51 about the power of volatility in capital markets? The lack of imagination. I mean, I read a quote one time hundreds of years ago to polyamaster talking and they're like, oh, he can't be a mathematician because he doesn't have the imagination, which is kind of like, but like if you think about math, really like when you think about like, and I'm not a mathematician, like how did they come up with? How did they think of that? Who thought of zero, right?

Starting point is 00:39:15 Like that is crazy imagination to think about the concept, negative numbers, what have you, that we take for granted. And that's what I think about volatility is like imagination. I'm not saying anyone predicted the pandemic, but like how quickly things can go upside down. Honestly, I'm not in the markets every day. I'm not using it as excuse, but like Silicon Valley Bank, it's kind of insane. They're a public company that is issuing quarterly earnings reports and the market saw the hole in the balance sheet.

Starting point is 00:39:46 It was reported. And no one was like, wait, why do you own $50 billion of 10-year notes? Why do you have unhaged interest rate risk of that size? Like, why don't you own three-year corporate bonds or, like, short-dated CLO, AAA tranches? No one questioned, and it didn't happen overnight. This happened, like, they were buying. Yeah, they didn't even have, like, a risk officer for like a year or something. I never thought a financial institution would blow up because of interest rate risk.

Starting point is 00:40:12 It's such a basic risk. It's like you can do interest rate risk literally, like, with a pen and paper. Patrick, how many 10 years you have? I've got 50 billion. And you don't have that much equity, Patrick. Like, you're like negative equity because of these, yeah, it's fine. You know, like, it just seems absurd that that happened. And it's like somewhat lack of imagination.

Starting point is 00:40:32 And it's not to be a doomsday or because really good things happen. I'm always in awe of great growth investors that have the imagination. Not that, you know, I was believing that we're going to have Tesla full automation of taxis and everything like that. But like, SpaceX is pretty amazing. Like, if you think about, like, if you said to me, 10, years ago, yeah, there's this guy, he's working on this thing, electric cars. You're like, oh, electric cars, that makes sense. And then he's going to do this other, like, space company,

Starting point is 00:40:58 and that's going to be bigger. What are you talking about? So I do think having imagination in investing is key. That's how you really understand volatility. Is there anything you ever did to stretch your own imagination effectively? What I tried to do is the narrative is becoming more powerful. You've tapped into that just in all your podcasts. But there's assumed narratives that are out everywhere. I think as a society, probably we're getting better at really exploring narratives and be like, is this really what we want as society? But in the financial landscape, there's so many assumed narratives. So I do think like exploring what does everyone believe and why is that true? Like it's a little Byron Katie that we were talking about before. It's like trying to understand,

Starting point is 00:41:47 What is the nature of a AAA rating? What does that really mean? It's never going to default? Well, could this possibly ever default? Yeah, yeah, it could. And has AAAs defaulted? Actually, yeah, they have defaulted. Mutual funds, I never knew that a mutual fund could gate.

Starting point is 00:42:03 2008, hedge fund gated. Tons of hedge fund put gates up. Wow, that's kind of scary as an LP. Like, they can just put your gate up. Funds are putting gates up now there's some funds. I never thought about mutual funds putting gates up. But now it like not consumes me, but like, this is going to happen again. I mean, I thought during the pandemic, you had no trading and corporate bonds happening, spreads widening every day, the search for

Starting point is 00:42:26 yields. Some of the big Vanguard PIMCO, and I'm not picking on them, like they became proxy like money market funds. You were getting zero in a money market fund as a retiree. You're like, I need some income. So you'd buy an investment grade fund or crossover fund. And that was effectively your money market fund. But there was no trading. You think about a money market fund, Mike Green talks about this binary of like index funds. When they get money, they buy. When they get redemptions, they sell. Like it's zero one. You get a bunch of redemptions and you can't sell any bonds because the market isn't open. What do you do as a mutual fund? You put a gate out. I don't think that most investors realize, most mutual fund investors realize they're subject to a gate. It's an open-ended fund. They think

Starting point is 00:43:09 that they have one or two-day liquidity. And if they put their notice in, they'll get it. get their money back. Yeah, it's interesting to go down the line and try to think of the beliefs that are most deeply entrenched or held and consider the opposite of those things. It seems like a really worthwhile exercise for literally everyone in any kind of asset class. Even if your money's in the bank. Everyone just went through this. Yeah. Wait a minute. How many people actually understood the FDIC insurance? I don't want to be like, oh, I mean, $250,000 is a lot of money. So it's like most people, it's like not an issue, whatever. You get these young founders. Oh my gosh, I just raised $10 million from my Series A and like I'm top of the world. And I put it in the bank

Starting point is 00:43:49 because I'm like 24 years old. And like I don't, I don't want to like, I'm thinking about that. I want it in a safe bank. Everyone's telling me, like, this is a great bank. Put it in that bank. Silicon Valley Bank. And you're like, wait, I have to deal with the fact that I'm a creditor to this bank. I mean, it didn't happen. But like, that's crazy. There's so many assumptions. But yeah, there's narratives that everyone believes. I think thinking about just their narratives. And sometimes it's who's a good investor, who's a bad investor. or what's a good investment, what's a bad investment. But then there's the structural. Lastly, I mean, I do think the Silicon Valley Bank gets back to this, but there's always asset

Starting point is 00:44:21 liabilities. Say a bit more about that, just like the nature of that concept. Well, the road to hell is paved with positive carry. So if you invest long and borrow short, usually there's positive carry. Like right now in the treasury curve, it's inverted. But most yield curves are positively slow. I mean, you think about all the blowups over time, a lot of hedge fund blowups, long-term capital, whatever. They're levered 30 to 1. Like, how come they blow up? Because their leverage is overnight leverage and they have longer dated assets. The assets get marked down and their margin gets pulled and they have to sell everything. That's happened. Time and again. Yeah, MF Global. It happened. I mean, that's what happened in Silicon Valley Bank. They had 10-year notes that got

Starting point is 00:45:02 marked down and their liabilities to deposits were overnight deposits. They all left and they went out of business. Private credit funds. My point with the private credit funds, there is an asset liability mismatch. A lot of these funds have leverage. The leverage is to some big banks that are sophisticated. And I'm not saying that there hasn't been any diligence done. There's been diligence done. But they have lent money. Their assets are long-dated loans. And they do not match the financing lines that they have with the banks. So if those lines have to be paid back, they're going to be forced to sell assets to pay those back. And that's where the asset liability mismatch comes in. I mean, a mutual fund has an asset liability mismatch. They're giving out one day liquidity,

Starting point is 00:45:46 and they might have assets that might take more than one day to sell. That's a mismatch. I guess in this case, the positive carry thing, it's just always going to be that way because the natural slope of the curve is what it is. That's probably going to always last. So you just want to be mindful of a breakdowns. How is an investor, you're getting back to your alpha? Like, where is the alpha coming from? And is it a time alpha? Is it an informational edge? Is it a liquidity? I mean, there is, you can get alpha in the liquidity. But if the alpha is coming from an asset liability mismatch, they can work for a long, long, long time. I'm not saying they're all terrible. Depends how much leverage. If private credit, if defaults don't come in, let's just say Q1 was

Starting point is 00:46:28 an outlier and we don't hit a recession and defaults drop off, then maybe the private credit funds, they'll never have to deal with it. Do you think it's fair to say that most people and the natural inclination is to be short volatility? Oh, yeah. I mean, short volatility is positive carry. Honestly, when you say someone wins the lottery, even though a lot of people that win lottery end up spending all the money, if you've been a financial advisor, one of your clients came in and said, I just won a billion dollars, you'd be like, well, you should take X percentage of it and put it in T-bills. you have carry. T-bills are 90 days, whatever, but a little bit short volatility that the federal government's going to keep rolling instead. Anytime you're lending money, you're short vol. I mean,

Starting point is 00:47:12 it comes back to the nature of if I'm lending money as a private credit fund, as a bank, as an individual, I just don't want the assets to go down of that entity. So I want everything to stay where it is. If I'm lending money and I have 50% loan to value, I have a 50% equity cushion, it can go down a little bit and I'm fine, but I don't want volatility. I don't really care if it goes up. That's the thing, you know, asset volatility, you can go up. All of a sudden, a billion dollar company's worth two billion and you've only lent 500 million. Oh, that's great. As a lender, if you had to choose, would you want volatility or no volatility, not knowing which kind of volatility you're going going to get upside or downside? You're like, I want no volatility. I don't get benefit of the upside.

Starting point is 00:47:54 How do you think about incorporating long vol in your portfolio or in your life? You said earlier, the key to vol is imagination. So many of the amazing things in life happen outside maybe the bounds of what we would expect or think are possible. So how do you think about incorporating the concept of more long volatility exposure, just in general, both financially and otherwise? I worked with an options trader, and this was like talking about listed options. He's like, you should never sell an option that was less than 10 basis points. He was just like, that's two out of the money, you don't want to be short that option. But if you reverse that and you're like, is there possible to buy 1,000-1 options, 1,000 payout, 5,000, 10,000? Yeah, I mean, in our lifetime,

Starting point is 00:48:42 I haven't hit on any personally. I don't know if you have. I've seen a ton that have happened. Whatever you think about Bitcoin, it was public for many years where you could be up 10,000 times your money and a bunch of other crypto. I think that's one of the reasons that Tesla has such a fandom is that there are so many people, probably more than any other stock, where people have made 50, 100 times their money. Elon can do no wrong. So thinking about how is the market pricing the probability? And I think once you get beyond that 1001, 201 realm, it becomes really inefficient. The pricing of the options are inefficient in your favor to be long of all. You should definitely not be short those. It's silly to be short those. If you can find them,

Starting point is 00:49:28 And I'm not saying you should just go out and try to buy 5,001 options. But we're just saying it's mispriced. I'm just saying like, yeah, as you get to the bounds of listed options, I see more and more mispricings as opposed to like at the money options. So that just tells me that like it's really, really hard. The log normal curve doesn't work. Yeah, option pricing, thinking about movements makes sense. When the outlier happens, the 10 standard deviation move, the 15 that we're never supposed to see

Starting point is 00:49:53 and we see them all the time, then it's interesting to think about is there. a pond that might have a bunch of those options in it. Stop me if I'm stretching here, but do you think this same concept applies outside of finance and markets? Yeah. Well, think about like just finding a spouse or partner. There's so many people that you could be compatible with and you find someone, they're a great person, a lot of alignment,

Starting point is 00:50:20 but there just isn't that one spark, but you're like, you know what, this is a great partner. This person checks so many boxes. but like there's not that one spark. But then you find that person that checks all the boxes and has that like one spark. You see people that find those people and they're like, wow, I didn't know that was possible. The right combinations of people in organizations. I'm a huge believer in synergy when it comes to relationships.

Starting point is 00:50:46 And that's optionality to me in a sense. Explain that a little bit more of the idea of synergy and relationships. What exactly you mean by that? Well, can I use a basketball? Of course, let's do it. Familiar ground for both of us. Yes. I'm a big Duke Coofs fan, and I think JJ Reddick, he's controversial, whatever. I understand why people don't like Jay. Great podcaster. Yeah, he's a great podcaster. He's really insightful. He's a bright guy.

Starting point is 00:51:12 And he made a point about the Celtics team. He's like, yeah, Jeline Brown and Tatum, Jason Tatum, who's a dude guy and I'm fan of. They're too much of the same player. So they aren't synergistic in a sense. You can't get mismatches. You do a pick and roll with those two, doesn't matter. Whereas if you do a pick and roll with Jamil Murray and the Joker, now you've got two mismatches. Chaos, yeah. Yeah, it's total chaos. So it's like if you and I have the same talents and we get along and we're compatible, I don't know if we have synergy, though. Do I make you better? Do you make me better? That's, I mean, I guess the synergistic effect, having the right combo. You can't have all leaders and you can't have all introverts. I mean,

Starting point is 00:51:55 it's got to be some mixture. Yeah, I love that idea. I think of the Joker and Jamal Murray is the paradigm you want to go after for sure. Say a bit about goal orientation as a concept in investing where I think in investing, it's especially in liquid securities or something where there's less salesmanship, you can just press buttons to buy and sell. We think of this is like incredibly like intellectual pursuit. You're just reading and studying and thinking all day, at least as I saw, it was less about goals. It's less about like an operating business where you're setting up things you want to accomplish and then knocking them down. What role do you think goals play, if any, in a successful investing career or process? I was more of the mindset.

Starting point is 00:52:37 It was like more of the infinite game. Graham Duncan likes to talk about. That was my mindset. Unsolvable puzzle that you toil that every day and you made some headwinds. And if you kept your process right and you're disciplined, you were going to get some nuggets that were fulfilling and there would be some alpha there. Like you were kind of mining for alpha in a sense. It's hard to set goals with respect to like every day, I want to get this much alpha or what have you. Yeah, it's like fits and starts and you're on the right path.

Starting point is 00:53:09 But there is a process of understanding when to cut bait and this isn't a good idea, this isn't a good position, and let's press here. So I do feel like it's more the infinite game. I do feel like I would say some of the hedge fund investing is a little different than the other alternative asset classes where it is more how much can we manage and how big can we make this. And that may work. Again, going back to the Blackstone and their real estate business, I feel like they've shot the moon using Game of Hearts analogy.

Starting point is 00:53:42 Like, I feel like they do, they have all the cards. They see everything. Their flow is better than everyone else's and like they've got a good sense. Scale is okay. It's okay. Scale is good. Yeah, scale is good. But when it comes to private credit, I don't know if that's right. I think you might be reaching a bit and justifying lending at top of cycles to, again, companies that don't have the hardest numbers and why are you making this loan? Well, because we need to raise the money to be the number one player. We want these GPs to come to us first. That's where I think goals can get in the way a bit. Have you learned any other interesting lessons from, I guess, sports is where my mind goes, basketball even more specifically, about teamwork or performance from having spent so much

Starting point is 00:54:30 time watching and studying sports? With respect to sports, I think the fact that the competition is always so fierce. I mean, if you think about, let's just go, it doesn't matter. I mean, NBA or NFL, the staffing, how come the staffs keep getting bigger and bigger? You watch a NBA game, there's like 15 guys that are coaches now. I think in 1979, the NBA went to like three coaches or something. And the NFL is the same, literally because it's the game within the game. There is just the little nuance of where do you get the advantage. I mean, remembering Bill Belichick wanted a left-footed punter because the ball spun the opposite way. And it's kind of an experiment where like everyone is playing by the same rules, same cap, same schedules.

Starting point is 00:55:17 How do you get an advantage? That's where I do feel like the best, as far as investor management, those firms never took for granted their lead. And if you see it in sports, why were the Pittsburgh Steelers a dominant franchise? Well, they were the first ones to really scout historically black colleges. They crushed it there. Billy Bean, obviously everyone knows. But like, there's always some alpha that they're mining, it feels like, to get to a better result in what should be like a 50, everyone should be 500 in a sense. So I do think, yeah, an investment management, like the firms that have always pushed the limits of like what makes sense and let's experiment. I mean, I think Jeff Bezos was thinking about his analogy, I'm saying, hey, you can wait for

Starting point is 00:56:07 a fat pitch, but the difference between baseball and business is that in baseball, you can always hit a grand slam, here you can hit a 10,000 run, right? Which is like imagination and volatility. Yeah, it's incredible to think about. I actually don't know the answer to this question. I saw that. I noticed this the other night at the Warriors game, it literally is like 15 guys with the same like gear on or whatever. It makes the seating all weird because the players end up sitting like further down and it's all this block of coaches. What are those guys doing? They all have a shooting coach. Now there's like a big man shooting coach and a three-pointer guy and Like there's multiple shooting coaches, trainers that are just biomechanics, making sure everyone's loose.

Starting point is 00:56:46 I mean, they all have the equivalent of offensive and defensive coordinators, plus the game management coach that just, hey, timeouts, fouls, how many fouls we can give. Again, then position coaches. Yeah, there's just so many. At the margin, if you think about it, the Warriors, I don't know, it's worth $6 billion. NBA teams are 10x in the last 10, 15 years. at the margin. Like, should you be paying a guy $300,000 as an extra coach? Yeah, like, why not? Yeah, yeah. Yeah, it's an amazing thing to watch and consider. I love the idea of like the game within the game and I think it's a

Starting point is 00:57:20 really clean analogy to investing. You dig in on some of these amazing investors and the degree to which they'll go to learn more, understand better. I mean, Ken Griffin. That place is unbelievable. If you dig in there, like, you kind of can't believe what you find. He takes nothing for granted. He made no assumptions. If you said that to anyone in Goldman Sachs, there's going to be a hedge fund that is going to start a securities business and dominate equity trading and equity options and make $7 billion in a year doing it. And it's going to be private. They'd be like, what are you talking about? That's like so silly. And he did it. Imagination is the key recurring I've only met him once and his imagination was definitely striking.

Starting point is 00:58:06 And rarely does like the first thing you notice about someone about like their imagination. Well, I think it's a great place to wind down the conversation, the notion of thinking about imagination in everything, misprice options everywhere is just a powerful, wonderful thing because of what could be possible. I ask everyone that I interview the same traditional closing question. What's the kindest thing that anyone's ever done for you? I mean, it's kind of cliche. It's my parents. I went to a college and they were like middle class And economics never came up. They were like, do whatever you have to do.

Starting point is 00:58:37 They did that with my brother and sister. And they just always had belief in us. That unconditional support is the kindest thing. Wonderful. Kieran, I always so enjoy our conversations. Thanks for your time. If you enjoy this episode, check out join colossus.com. There you'll find every episode of this podcast complete with transcripts, show notes, and resources to keep learning.

Starting point is 00:59:01 You can also sign up for our newsletter, Colossus, Week. where we condense episodes to the big ideas, quotations, and more, as well as share the best content we find on the internet every week.

Invest Like the Best with Patrick O'Shaughnessy - Kieran Goodwin - Imagination, Volatility, and the Pursuit of Alpha - [Invest Like the Best, EP.331]

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