My guest today is Kieran Goodwin. Kieran spent over two decades at the frontier of 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 today, which forms of alpha he’s most skeptical of, and the blend of EQ and IQ necessary for success and investing. Please enjoy my conversation with Kieran 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
(00:03:00) - (First question) - His view of the state of private credit in capital markets
(00:06:56) - The notion of ball washing and why it’s important to understand 
(00:09:04) - What the worst-case domino effects of ball washing could be 
(00:12:21) - Arriving at a place where JP Morgan could borrow so much at the fund level
(00:14:20) - Lessons learned from the worst trade he made 
(00:16:53) - What could happen in the world of private credit in the next few years and how the bigger players tend to benefit 
(00:19:29) - Thoughts on the world of venture capital right now  
(00:21:13) - The time he was at the peak of his power as an investor
(00:24:03) - From being new at something to incredibly successful seemingly overnight
(00:26:42) - What kinds of alpha he believes exists and which ones he’s skeptical about
(00:29:30) - Thoughts on income share agreements 
(00:31:24) - Why there aren’t more initiatives for new talent to trade their student loans for future earnings 
(00:33:13) - The power of EQ over IQ and why it’s important for investor success
(00:35:49) - Whether or not now is a good time to get into the field of capital markets
(00:37:54) - Key tenants to know when learning credit investing specifically 
(00:40:09) - Things people misunderstand about the power of volatility 
(00:42:39) - Ways he managed to stretch his own imagination effectively  
(00:48:06) - The natural inclination to be short volatility 
(00:49:24) - Incorporating long volatility into his portfolio and life  
(00:52:20) - Thoughts on synergy in relationships  
(00:55:48) - Other interesting lessons learned from sports
(00:57:50) - The roles of the multiple coaches that sit in for an NBA team
(00:59:42) - The kindest thing anyone has ever done for him

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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.

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 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.

Kieran spent over 2 decades at the frontier of 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 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.

You had this asset class that was somewhat of a cottage industry around the time of the Great Financial Crisis.

Probably the most important is that rates went to 0.

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 6 times EBITDA.

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, there was more demand 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 0% as so for LIBOR, LIBOR at the time, now SOFOR, and spreads being 550 to 600, you're getting 6%, the funds needed to lever themselves to get to 8, 9%.

If you're an alternative asset manager and you're coming to an LP and saying, I can give you 5, 6%, no 1 cares.

It's gotta be like at least high single digits.

And what the allocators loved was there's no volatility.

Jason Zweig at Wall Street Journal wrote a great article talking about how Cliff Water, who's not only a consultant, but also in private credit, put out on a fund a 10 Sharpe ratio.

He interviewed Professor Sharpe, I can't remember his first name, and Professor Sharpe 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 there's vol there's vol to anything.

Your car leaves the lot and it's down 30%.

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 5 to 7 year loans, loans made in

The companies thought they were gonna pay 5 and a half, 6% interest on, and now those are 11% interest loans.

And if you think about the typical private equity middle market company, they were bought at 12 times EBITDA, they put 7 turns of leverage on it and 7 turns of leverage only allows You use all your EBITDA you can pay 14 points to 8 or so whatever percent interest So now you're paying 11 where you were paying 6 There's a lot less room for error right now.

And we haven't seen that interest really flow through because like these rates have been 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.

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 LBOs before the great financial crisis.

I would say there's probably more excess in private equity in the middle market space than anywhere else, and the 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 EBITDA space than 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 vol 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, from the end customer, the asset owner's perspective, just think it's like a neat, interesting concept.

You think about institutional allocation to alternative asset management, we'll start with someone like David Swensen, 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.

When David Svensson first started, he was probably the chief bottle washer and was looking, meeting private equity guys, meeting hedge fund, real asset managers.

And now within a place like Yale or any other 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 power position in the last few years.

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 can make 15% forever with no volatility like

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've seen in the high yield markets, we've seen 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 like what you think could be the domino or domino effects here?

Because a whole idea behind bull washing is a lot of this stuff happens very slowly.

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.

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?

What could happen is given that to achieve 8, 9, 10, 11% net to investors, if you were involved as a GP, if you were in a direct lending market, you were making loans at SOFR plus

you had to have leverage at the fund level.

So you went to a Goldman Sachs, Citi, JP, all the big banks, I'm gonna lever this fund 1 to 1.

So if I have a billion dollar fund, I'm gonna make 2000000000 in loans.

I'm gonna borrow a billion, and they would give you a line of financing.

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 gonna be par all the time.

That's part of the vol washing in a sense.

There's arguments to be made for or against that.

We don't necessarily have to go there, but defaults are real.

When principal comes due, you pay me or you don't, And yeah, we can do amendments, what have you.

But end of the day, it's not performing as defaults 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 in the higher end of the market.

If that trend does continue, 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 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 just the process of selling a loan as the GP, you're gonna have to tell your borrower, like, listen, I'm gonna take this private information, give it to a third party to evaluate the loan, see if I can sell it.

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 and the lenders have a very good track record.

If 1 of these or 2 of these situations happen, all the other banks will know this is happening and they're gonna start, okay, who are our worst performers?

The correlation of, hey, this is not an issue, and they're gonna be able to pay us back, that goes from nobody has a problem to there's a lot of problems really quickly.

The billion dollars in your example, that's debt capital from JP Morgan or something to the fund.

Talk a bit about like the origin of that piece.

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.

I just feel like maybe the system is getting a sense that-

As we've seen, private credit is 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

The fund would just say like, Hey, listen, I'm going to raise a billion.

So you have 50% cushion on these loans, which are all first lien loans that would have, again,

So, let's just do diversity of the loan pool and what would have to happen.

then the bank who's going to lend the fund money is saying, well, if I lend at LiveWorths 250, 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.

If you think about where we were with 0% rates and deposits, a place like JP Morgan, Bank of America, Goldman Sachs, they were taking in money at 0.

And now they're lending it out live plus 250, 300, and even live was 1%, 2%.

But now their deposit base 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, so back in the summer of 2002, I was trading prop at UBS and I had a position in WorldCom.

The other debtor, WorldCom, was trading decently lower the further maturities.

1 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 dollars 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 gonna pay for my short.

I was actually overall bearish at the time.

The only way you could get crushed was fraud.

It's good to know what's going to kill you and it kills you.

Really, at the end of the day, Bernie Evers went to jail.

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 threes and the global crossing went down, Worldcom and AT&T were still growing.

In 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.

When you're thinking about the explosion of middle market private equity, I mean, absolute explosion in the last 15 years.

Oh, 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 EBITDA, there is this notion of hard and soft.

But in a tougher market, everyone wants hard numbers.

Like if you had to handicap it, what do you think happens in the world of private credit in the next 3 years or something like that?

Well, I mean, let's just say in the law of 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.

I just don't think the talent is evenly distributed and there's gonna be, I'm not saying who it is, but like it's gonna 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.

Institutional allocators are like, wait, I'm not always going to get 9% back.

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 1 to think about.

You always hear like these funding cliffs, like, Oh, so much commercial real estate, all this is due.

And like I've heard this always how you in market next year, there's so much, you're like, there's always a lot of maturities due.

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.

If SOFR's at 5% and leverage is probably down from Normal middle market company would be 12 times EBITDA.

They're lending at 7, maybe they're lending 5 and a half turns now, but it's still SOFR plus 6%.

Again, there's limits on how much interest.

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've thought about it a little bit and met some people that do that style of investing and understand the setup.

I mean, again, like much like private credit, it was a cottage.

I mean, there were some big players, A16Z and Sequoia and a bunch of others, a massive established players, but there were a lot of small firms in venture at the time of the financial crisis, and they had a ton of growth.

And then there's been so many, 2 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 a much easier to set up 2 people, you and I let's do a fund.

We raised $13 million, really hard to do in private equity.

No 1 cares in private credit, hedge funds, the fixed 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 in drawdown vehicles, whether it's private equity, private credit, real estate, or venture.

They were getting capital back to 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 1 out of our 15 managers.

I think there's gonna 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?

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.

And I started in credit derivatives in 1995, almost by default.

I was trading interest rate options and move firms.

So that means for the first 3 years, I just talked to myself.

I mean, I had credit derivatives trade around my car, business card.

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 to 02, super volatile time, really high volatility in the equity markets, but also in the credit markets, really, really high volatility, which is 1 of the reasons like convert hedge funds did so well.

They had amazingly high equity volatility that they were hedging against.

They had like kind of the best of both worlds.

So then I traded prop for a couple of years when I was trading prop, cause I'd started in the credit derivative market, like I almost knew every trade that was happening.

I kind of knew 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 surprising and understanding the origin.

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Kieran Goodwin - Imagination, Volatility, and the Pursuit of Alpha