My guest this week is Scott Goodwin. Scott is the co-founder and managing partner of Diameter Capital Partners, which he started as a credit hedge fund in 2017 and has expanded into a $13 billion investment firm that covers all credit markets. Scott spent the first 8 years of his career at Citi where he rose to head of High Yield Trading before moving to Anchorage Capital in 2010 where he led their global trading desk. Scott is one of my favorite examples of the joke I used to make about this show, when I said it should be called - "This is who you're up against." He's one of the sharpest investors I know and I'm sure you'll see why. Please enjoy my great discussion with Scott Goodwin.

Founders Podcast
Founders Episode 136 - Estee Lauder
Founders Episode 288 - Ralph Lauren

For the full show notes, transcript, and links to mentioned content, check out the episode page here.

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Show Notes
(00:03:07) - (First question) - Comparing the investing themes of the ‘10s to the ‘20s
(00:04:59) - The skillset differences between investing in equity versus credit 
(00:06:28) - Why Carvana’s stock plummeted and thoughts on the destruction of value
(00:07:33) - General overview of credit cycles and what they are  
(00:15:42) - Opportunities come from knowing the names well enough 
(00:19:17) - Making substantial decisions in a matter of minutes as a credit investor 
(00:22:23) - How he thinks about the evolution of sourcing alpha in credit markets
(00:27:37) - Why so many institutional capital pools have fewer credit managers  
(00:31:08) - His childhood and the unique aspects of it that set him apart
(00:37:28) - Lessons learned early on about running an investment firm
(00:43:34) - The role imagination plays in credit investing
(00:46:35) - How weekly breakfasts lead to an investing partnership
(00:50:51) - What Tracy Fenton has done for Diameter
(00:53:05) - Things that should change about investing firms writ large
(00:57:09) - Calling balls and strikes and how his team learns and works together
(00:59:37) - Why he’s motivated more by failure than success
(01:00:54) - Where he finds the most joy in his investing process
(01:04:07) - Non-negotiable attributes he’d look for when investing in other GPs
(01:05:22) - New variables that have his attention in the current market
(01:08:27) - What feels like unfinished business to him
(01:09:43) - His reaction to everything going on today in real estate
(01:10:52) - The kindest thing anyone has ever done for him

Before we transition to the episode, I want to highlight the Founders Podcast, which is part of our Colossus Network.

David Senra, who hosts Founders, has devoted his life to learning from history's greatest entrepreneurs and every week he distills the lessons of a different founder.

If you want an entry point, I highly recommend starting with episode 136 on Estee Lauder or episode 288 on Ralph Lauren.

I hosted David on Invest Like the Best last summer, and it's hard not to walk away insanely energized after listening to any episode with him.

You can find a link to founders and those episodes in the show notes of this conversation.

You can also search all past transcripts on our website, joincolossus.com.

I'm Patrick O'Shaughnessy and this is Invest Like the Best.

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 joincolossus.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 some or O'Shaughnessy asset management.

This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

Clients of positive some or O'Shaughnessy asset management may maintain positions in

the securities discussed in this podcast.

Scott is the co-founder and managing partner of Diameter Capital Partners, which he started as a credit hedge fund in 2017 and has expanded into a $13 billion investment firm that covers all credit markets.

Scott spent the first 8 years of his career at Citi, where he rose to head of high yield trading before moving to Anchorage Capital in 2010, where he led the global trading desk.

Scott is 1 of my favorite examples of the joke I used to make about this show when I said it should be called, this is who you're up against.

He's 1 of the sharpest investors I know, and I'm sure you'll see why.

Please enjoy my great discussion with Scott Goodwin.

All right, Scott, maybe an appropriate place to start would be to compare what you think of as the theme of the 2010s with what you think the theme will be of the 2020s across investing writ large.

If I look at the 2010s, it's all about private equity, shareholders, return of capital, dividends, 0 rates.

Now you're in an environment driven by inflation, higher rates, likely return of that capital to lenders, pensioners, savers, creditors who are robbed of it in the 10s.

You have this transition back that takes a long time.

That's the theme that I like investing behind for the 2020s, which is exciting from a credit perspective because we're yield investors and credit investors.

We haven't had that opportunity really since

Give some tangible examples, little anecdotes or something of how this might start to play out.

If you're sitting there as a pension and you have a 7% bogey or 8% bogey and your equities are at all time highs, and now you feel like, now I'm funded, I'm going

to start to rotate into investment grade corporate debt.

You can buy 30-year investment grade corporate debt now yielding 5 and a half to 7%, depending on the credit quality.

And that starts to be a meaningful defeasement of your liability relative to equities that might have more convexity, but you don't need that convexity anymore because you can defuse your liability.

You also have the other side of it, which is a company just has too much debt, has been zombified by COVID.

Maybe there's too much debt on the capital structure, but because rates were so low during COVID, the coupons are low.

The bonds are trading at 60 cents on the dollar, 70 cents on the dollar.

They're not defaulting tomorrow, but the creditors are essentially the equity.

And eventually there's gonna be that transfer of value back to the creditors.

So those are 2 kind of barbell examples of how I think it will happen.

I think there's different personality types that thrive in equity versus credit.

I know early on in your career, you figured out that equities weren't for you.

Maybe describe in your mind the prototypical skill set differences between those 2 types and who would thrive the most?

Well, Morgan Stanley didn't want me back after my junior year summer.

So equities weren't going to be for me because they didn't offer me a job.

And in credit, you're always thinking about how much can I lose?

Or is the thing about the smart equity investors I know, who have the last 10 years made a lot more money than I have because they've been thinking about the upside.

How can earnings or revenue for this business double, triple, quadruple?

So that difference of thinking about downside versus thinking about upside is very fundamental.

And then when you think about credit investing, you have the asset side of the balance sheet, which the equity guys are focused on.

So how many widgets does this company make?

But then there's the liability side of the balance sheet that the equity universe, frankly, misses a lot.

I think they're learning about it again now a little bit.

Thinking about what Carvana or companies like that have gone through.

You're seeing the liability side start to matter more, but what's the debt structure?

So that liability structure and sort of the unholy acts that can be done by creditors or to creditors is something that we like to meld into our process from a credit perspective.

You've raised Carvana, such an interesting example, just because people listening can probably visualize the stock chart.

And you see a stock chart like that, and the obvious question is like, how could this happen?

The amount of destruction of value for the equity over, let's say 18 months or something like that, just seems at odds with what we think about how markets function almost.

How could it be that it was valued at this and now it's valued at this?

That example is a finance company that was doing really well when rates were 0 and people believed in a huge TAM.

Now people realize that rates are not going to be 0 forever.

So their finance business, effectively subprime finance business, isn't earning as much as it was.

And they're just not that good at selling used cars.

But I think you go into bubbles and the Fed inflates and deflates them.

And the 1 we're on the precipice of deflating right now or in the process of beginning to deflate, driven by tech, healthcare venture, private equity and 0 rates and private credit.

Where can I put my money where there's convexity?

When there's no yield, people hunt for other ways to get convexity or optionality.

Can you talk about the concept of a credit cycle, which listeners will be roughly familiar with, but I think drives a lot of where the opportunity is.

And I want to talk about in the credit cycles that you've seen and or studied, but really seen and participated in, how they felt different, maybe going back to like, say, 2000, so that we can talk about this 1 specifically and how it's different.

But first, what is a credit cycle from your perspective?

So when we think about credit cycles, we think of booms and busts in business, booms and busts in the economy associated with companies that are either cyclical, that have a problem due to an economic change.

So in COVID, that meant rental car companies and cruises and airlines that literally couldn't perform their business.

Their balance sheets were fine 1 day and not fine the next day.

And then you have another type of credit cycle, which is more driven by secular change.

So Amazon killing all the retailers over the past 10 years.

There are series of micro cycles going on all the time in different sectors.

Maybe the energy thing in 2016 is the best example of that.

If I unpack that and go back, I started at Salomon City in 2002 working for Jim Zelter and what kind of the learnings were from him early on, it was there are a lot of companies that need money right now for project finance in telecom and power.

And there was a series of asbestos bankruptcies as well.

That was a bubble built up largely in the high yield market, tradable bonds, investment grade market, power, telecom and fraud were the main parts of that credit cycle.

There was a huge amount of money to be made in distressed because you had mutual funds that would bond default or they get downgraded and they sell them to the stress guys.

And there wasn't as much competition for those people in distress.

And the liability side of the balance sheet we talked about, those people had real edge, go to the courthouse.

They would have lawyers, they would know exactly what was going on.

That liability side edge, because of the advent of real research and everybody having a doc person on staff has largely been competed away within the credit universe.

So if you think about LBOs and probably 40% of high yield issuance was driven for LBOs in 2007.

I don't think we've seen that number since then.

And there was a ton of leverage built up in the system very quickly, chasing a private equity boom.

You had a housing bus that took the economy down, that took those deals down as well.

So those companies weren't actually the problem.

It was the housing bus that took the economy down, that caused them to have a problem.

That was another very fast V for a lot of those companies.

I was at Citi and then left in 2010 to go to Anchorage.

But I'm at Citi, my mentors, Jim, John Eckerson, Ronnie Mateo had all left.

I'm kind of there by myself with a few people who are left, moving the deck chairs around, watching the stock be at a dollar, and frankly, learning from my clients.

1 of the reasons I went to Anchorage was I had a lot of the same shorts as the Anchorage guys in 08, and we worked to turn them into longs in 09.

A lot of my career has been about finding shorts, then getting long the other side and following these credits through the cycle.

And I liked how Kevin and Tony and the Anchorage team did that.

So they asked me to join in 2010, and I joined them coming out of the GFC cycle.

But then soon after that, we had a cycle in Europe.

I got there, I think, in May of 2010, and all of a sudden, Greece was exploding.

Frankly, the learnings from the European sovereign cycle were very relevant to what happened during COVID, because it was the first time in my career that you'd seen real intervention by sovereign corporate debt markets buying a lot of debt and supporting the market.

So you had in 20, in DRAHI, whatever it takes, they're going to buy Italian bonds, buy Spanish bonds.

Eventually, they ran out of those bonds to buy.

They bought corporate bonds with the CSPP program and then distorted the corporate bond market in Europe for a long time, which allowed REITs to issue at 1%.

That's going to now create a good distressed opportunity.

But what we saw then was whatever it takes intervention works in investment grade and corporate bonds.

That's a real credit cycle sector driven like I was talking about.

So there's a ton of new issuance in energy.

The shale boom is being built up over many years.

I remember meeting with Aubrey McClendon from Chesapeake in 2003 or 2004 at Citi in a roadshow.

I think they issued the Chesapeake nines that year, the nines of like 08 or

And he showed us a chart of where natural gas was gonna go.

And I don't think it saw that target for a long time.

But that was the beginnings of it, like in the early 2000s.

At Anchorage in 2010, 11, and 12, we were financing companies in the Bakken, the Marcellus, the Mississippi Lime, the Permian.

So when energy started to trade poorly in the middle of 2014 and start to trade down a lot, and you start to have these high correlation sell-offs, that's 1 characteristic of credit cycles is, whether it's a sector-based cycle or it's a macro cycle, the beginning sell-off in credit is 0 dispersion, high correlation.

That creates tremendous opportunities because in that first wave, things will go down that probably shouldn't have gone down at all.

And you can buy those and short the bad stuff.

So we looked at that first sell-off in 2014 and you had the Permian credits, many of which have now been rolled up, the Parsley's, the Crown Rocks, the Diamondbacks had gone from par to 70 cents on the dollar.

The Mississippi line, which is a worse basin, the Sand Ridges and the offshore credits had gone from say par to 50.

The distressed funds are all looking at the stuff at

They're heuristically saying, I have to buy the lowest dollar price.

They don't have sector specialists, although that's changing because of some of the mistakes made in the teens.

But they're drawn to that low dollar price.

We're sitting there saying, wow, this stuff in the Permian is covered at par, even if oil is at 30 or

Whereas the Mississippi Lime stuff, we didn't like anyways.

Let's buy the Permian stuff at 70 and short this at 50.

And that trade ended up making maybe 30 points on the long and 50 on the short.

In extremis, that's what it would have made.

But you had multiple bites at the apple and fits and starts in that credit cycle.

Rarely do you go like COVID from A to Z in 1 month.

Credit cycles are, and the 1 we're about to talk about, the post-COVID cycle that we're about to enter now is, it's a slow moving cycle.

Much more like the 02, 03, 04, 05, what I went through at the beginning of my career, which was a buildup of excess in certain sectors driven by some economic shifts and changes in the interest rate environment that led to a cycle.

The things in 2011 and 12, systemic, GFC, systemic.

Energy, not systemic, but commodity price.

If you have a bond that's at par, that works at $70 oil, and all of a sudden oil's at 20, it doesn't work.

It's not that the bond's worth 50, it might be worth 0.

Now, what happened in the energy thing was you had all these bonds that went to trading at 0 to 20 cents on the dollar.

But some of them had a couple of years of cash around and could fund their interest payments.

He said, well, I can buy for 5 to 10 cents.

But I think about the best trades I saw in 08 and 09, it was people coming in and buying the LBO and secured debt.

I was at the broker dealer at Citi because there was a lot of option value at those spots.

Now we're sitting here at Anchorage and we've got, wow, there's some really interesting opportunities.

So we try to figure out which one's had enough runway and it's same thing happened again in COVID.

And you ended up buying what were IOs that recovered par, because oil didn't stay at 20 or 30 bucks forever.

It went back up eventually because supply and demand balances.

And I think in commodities, you had the same thing in Freeport and some of the copper companies as well.

When you have a commodity, a first quartile or second quartile commodity company that trades down a lot in credit, it's a really unique opportunity because the commodities have such a high volatility factor associated with them.

If they have enough runway that they can last

to 24 months, you're supposed to take a shot on that debt.

And is the opportunity a function of knowing the names incredibly well?

Seems like a theme across the stories in your career is you get, you said, multiple bites of the apple.

If you know a name well enough, you end up dealing with the same company, the same credits like over and over and over again.

And so speed and familiarity become key components of the opportunity to do well in these displacements.

You'll hear if you walk around the floor of diameter and we've got, I think, almost in the low sixties of people now going to 70 pretty soon, you'll hear know the names echoing through the walls and the halls.

We're not kidding because credit is an asset class that is naturally very different than equities.

It's a carry-based asset class, you get your coupon.

Equity investors are looking for total return.

We're approaching credit not from a get my coupon mentality.

We're approaching it from a total return mentality.

And if you want to approach an asset class that is carry based from a total return mentality, that means you have to see where the ball is going.

They have to buy this duration of bond or this rating of bond or this sector of bond.

Most of the credit money is in structures away from private credit in mutual funds or ETFs, not most, but a decent amount of the credit money is in those structures that have to say 30 or 40% of the high yield market, less the IG market, but have to leave, can leave at any day.

If you can leave any day and you have an underlying market that has discontinuous equities over the counter market, you better be ready to make decisions quickly.

And I think that's something that my partner, Jonathan, and I really put together when we were building Diameter was, we want to develop a process, and we had built this at Anchorage, but we wanted to put it almost on steroids of how can we be a provider to liquidity into inflection points in markets, credits, and sectors?

Because the banks aren't sitting there providing liquidity anymore.

When there's a big seller or something, when there's an inflection point in a credit, a downgrade, an upgrade, an M&A event, a bankruptcy, any sort of event that causes a lot of trading, we don't want to be just starting our research then.

And if you're just a distressed person that's reactionarily looking at what's in distress, you're going to be starting then.

But if you're looking at the market every day, you're doing new issue, you're shorting, You have a CLO business that looks at new issue and knows all the loans.

You're forced to think proactive and thematically.

So we want our analysts, our telecom analysts, is focused on level 3 right now in the distress space to also be thinking about whatever's happening with AT&T and Verizon and T-Mobile that might impact the distressed telecom names.

It's that full cycle investing within a sector being very sector specialized on the research side and then product specialized on the trading side that I think allows you to make fast decisions because if you're not product specialized in trading and you're a tourist to say investment grade, or you're a tourist to high yield, or you're a tourist to distress, you're not necessarily gonna get the call from the bank when there's that opportunity.

If you're in the market every day, they're gonna call you, and our process for our hedge fund and our drawdown fund doesn't have an investment committee.

We work together on them and his background is much more research restructuring legal minus trading risk portfolio management.

That comes together when we both love something, we can make fast decisions at those inflection points, but it's because we vetted and we have a list of names with each analyst that we've already vetted with them and then we update on each quarter.

Could you give a story, hypothetical or real, that helps us understand, like 1 of these decision moments where it is seconds or minutes that you're making, I'll call a substantial decision, whether that's with dollars or percent of the portfolio or however you want to interpret it.

I just want to get in the room a bit on why this all comes together as an advantage for you and your investors.

That's maybe the most interesting example.

The levered loan market is a market that is very opaque.

of the market is private issuers, which means there's no public stock you can file.

You have to go on the interlink site to get the financials.

And levered loans don't settle like stocks or bonds.

It's mind boggling, but levered loan settlement process could take anywhere from a week to months.

Hopefully someday blockchain will fix that, but it hasn't yet.

So we're sitting there in the second week of March, and we share with the banks the names we're focused on.

So I'm sharing with the banks each morning, here are the names we're focused on.

So they know if they get a seller of anything on that list, they should call me.

We want to be transparent and open with them.

Again, we're trying to make them smarter.

We're housing that risk, they're looking to move it.

I'm sending them an IB and then I'm also talking to them.

For each bank, sort of nuance the list a little bit, as are the traders on our team.

And the head of loan trading at B of A calls me.

I've got a mutual fund that's got a billion dollar outflow in loans.

They're calling us because we have the fastest settlement process for loans.

Can you buy 500 million by 8am because they want to make some progress?

We're like, let's not buy cyclical stuff.

We don't know what's going to happen here.

We're starting to buy a little bit of IG, because we think the government's going to start buying IG, but this is junk-rated loans.

And we had had our analysts in software learn all the software loans in 2019, because we said, well, if there's a recession and there's a cyclical environment, the whole loan market's going to trade down, because that's where a lot of the excesses are building up, but software will be the most defensive place, the stickier.

So we bid that firm for 500 million of loans, of which 350 was software loans.

Let's say the average price on them the prior day was in the high 80s.

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Scott Goodwin - Know The Names