CrossingBridge’s Sherman on Return of Capital

We're looking at rating actions that have happened in the past, which you know, if you're looking across investment grade and high yield, has been broadly positive. But we also look at just broader sentiment looking forward from the rating agencies, which when you're looking at that piece, it's looking a

little bit more negative, especially for high yield companies. So in terms of how the current events might impact that, I think you're just again going to wait and see, you know, how long this might potentially last, and then I think it could be a little bit more sector focused if rating agencies do decide to start being a little bit more pessimistic. Obviously energy being the big area where companies might start to see a little bit of impact just with where prices are headed and overall supply

that's heading into the market there. So yeah, overall though, like I said, positive in terms of what they've been doing, negative kind of looking forward, especially on the high yield side.

return on capital? And what kind of of risk am I taking on that capital? The next question is am I being compensated? In fixed income? In particular where you have were ned upside right? You have whatever the prices versus par so if you buy the discount, you have that amortization at discount, and if you buy it at a premium, it's going to par But you're going to

pars where you're going one word or the other. So the real question is if par is where I'm going most of my return, if not all of my return is from coupon or embedded coupon. So you're not playing like an equity for some big upside, you know, and if you lose money, it takes a long long time to make it up. So the first point is how

do you make sure you don't lose money? And I think in River Parks Strategic Income, we've illustrated that although our upside capture versus peers is not in the top quartile, our die in side capture is dramatically in the top quartel. When you do that over a long period of time, you actually get significantly better compounder returns.

is you know a business model? So for instance, today in the Nordic bond market, they're issuing a bond on heated Teddy Bears and it's a very popular product that's been around for a long time, and the borrowers doing what they call divn and recap. He's taking money off the table to put into his pocket. And he's doing this because he's moving his citizenship to Ireland. And there's a state reasons and tax reasons and they're all perfectly

fine reasons. It's not like I think, you know. The CEO who's run this business at the Entrepnore from beginning knows something that no one else knows. It's a really good business. It's been growing every year in recessions. It's grown. It's not it done here. It reminds me a little bit of build a bear. However, it's still a divner recap and it has very little leverage, meaning that debt divided by cash flow is is very minimal. And a friend of mine set, are you going to buy the

teddy deal? And I said no, and they said why. I said, well, the way I look at it is, do we want to run a Teddy Bear company if things go bad? And what is there to salvage in the Teddy Bearer company if they go bad? So my friend said, well, do you think it's going to about it? I said no, I think it's absolutely fine. I think you're probably gonna make your money, You're gonna get your Cooper nuts are gonna work. But if it doesn't, what's planned?

B There is no plan being a consumer one product that's heated Teddy Bears where the entrepreneur doesn't choose to support it.

pe ratio or a cash flow ratio. What is my total debt or at least a debt where I am in the capital structure in comparison to the cash flows that one would expect over time. And you cannot ignore two sub sectors. How much debt can the company put on equal or senior to you in the future, because when they can, they will right. So how much can you have what they call prime to put on top with you? And what does that change your ratio from a cash flow standpoint? And the second substant is what

does working capital look like? Because working capital is one thing I think most analysts across the board really undervalue and don't really appreciate the less working capital but by far debting currents and the multiple so it's no different than if you were a real estate investment you said, what's my cap rate? Right, it's effectively the same analysis.

opportunity and you find an opportunity. And in that case, I have no problem with the fund taking a four or five percent position in those situations because there's so few and farm pine with the caveat, we have to feel one hundred percent comfortable that when the bonds get paid off, they will get paid off in accordance with the amount that you've invested your full nun So buying a bond at sixty where you think you're going to get two coupons of ten percent, your actual cost is forty, right,

sixty minus two coupons ten plus ten is twenty gets you forty. And then say, well, we think it's worth forty cents. Well, then you earned a zero return of your money for two years under the hope you're going to get coupons which aren't tax efficient for a piece of paper that's worth forty. That is not a fat pitch. That is not opportunistic. And by the way, part bonds can be opportunistic, you know, give you example a while back, we got involved in Viacom, and then let's go back

to twenty eighteen. But what's interesting is things repeat themselves, right, think a paramount of Warner Brothers today. But in Viacom, CBS was going to acquire Viacom, and CBS that traded at a very tight spread, and Viacom traded a very widespread and the market wasn't appreciating that they were effectively the same credit. Right, And to me, even though it was investment grade, the fat pitch was the spread was so wide that you take the longest day to paper

you can find to get the biggest spread. You take out the interest rate risk by shortening or hedging against long term treasuries, so you're just long the spread, but you're not a credit default swop where it's a five year with an average life of two and a half. You've got a long day to piece. And then when people realize the conversions. Assuming I got the analysis, the team got the analysis correct on CBS, you're going to get a big returner cap on It was an investment grade world.

the spectrum. So I'm wondering for you where you seeing value across those asset classes right now.

platform that the Nordic market offers. Because the Nordic market, you should think of it as not issuers that are Finland, Sweden, Norway, Iceland, Denmark. You should think of it as a platform like Nasdaq, is a platform where issuers can come whether they're European or US and access it is a form of barring money at four hundred million dollars or less, because the only other people that lend to four hundred million or less, like one hundred and fifty or one hundred or two

hundred are direct lenders. So it's a direct it's a direct competitor direct lending. So that's where that's Warren area. We can go through more, and I do want to be clear your listener. Strategic income is a conservative high yield funding that it's typically I mean, ideally in a fat pitch world, it's one hundred percent high yield, but we've not really been in one hundred percent highield very long in that product since we started the product back

in twenty and twelve. But like right now, it's about forty percent investment grade and cash are pretty close to it, which tells you how you feel about spreads. I mean, we've written a lot that you're you know, you're not getting paid a lot over treasuries in the market in general.

one hundred years. I'm not sure I want that kind of bottom up duration risk. So I kind of want to jump in again.

We've seen this in the whole BBC Private Len World conversation that's going on as we speak with Blue Owl, not to pick on them, but literally everybody else. So one of the things I think from an outsider perspective is it is important to think about what is the stability and flows of the underlying vehicle that you're investing in, whether it's a hedge fund, a private fund, an interval fund. There was a good article I think Bloomberg did or somebody did, on the life of interval funds and when

they load up and when they get redemptions. We have dairy liquidity, so by definition, we have a mismatch and assets and liabilities. Right, our borrowers are like savers at a bank, Right, they have daily liquidy. So we're fundamentally mismatched to start with. We lend long and borrow short. Right, Our customers are our liabilities. I don't mean them negatively, but that's so. I think understanding your asset liability match helps solve some of that problem, David. And then why

don't you explore the question further if you want? And I can add to it. But I think that's an important top down that people have to think about, is we're your asset liability matches.

I think you were kind of alluding to a little bit lower of a supply there, just wondering, you know, looking forward, are you seeing maybe that that might start to kind of increase in terms of opportunities there, or is that something that you're just not really you know, keeping all that close an eye on in terms of maybe how the FED might impact some of these companies that are on the lower end of the spectrum.

bankruptcy law has matured. You have different constituencies buying distrept papers such as clos which make a different alignment of interest is very different, let's say, than an opportunistic investor. Right their goal is to kick the can down the road and maybe not cleanse the balance sheet. Particularly, and you have this lovely credit or on credit of warfare in the United States where literally the song from Hamilton you want to be in the room where it happens

is takes a whole new meaning. So I find the distress market here, particularly of the larger opportunities, less interesting or have inherently more risk than what I'm traditionally used to. So as a rule, we look at distress always where how can we SOLVEREI our own problem with our own capital. So by definition, if you're a four billion dollar farm and a big positions five percent, like, that's a huge position,

So that's two hundred million. If we can't solve our own problem with two hundred million, then who's coming to the rescue for us? So it does limit too. I think you're seeing less true distressed because of liability management exercises lemies, and that's a functional alignment of interest in how things are done. And these costs are out of this world. The people are making all the money are the financial advisors. I mean, somebody just go buy a

whole bunch of stocks and financial advisors. It's very different in the Nordics, and I'm not their problems with the Nordics, but there it's very different. So in the stress world, where we see typically opportunity today is post lemy post liability manager exercises where we can look at the securities that are top of the capital structure with good covenants and issue to make money for the original holder. We're

now that holder, call it a hedge fund. An opportunistic holder is looking to move on and recycle their money, and they're willing to give up a ten to twelve thirteen percent piece of paper top the capital structure, make more equity type return, and we like to be a provider of liquidity, be a natural transition, and as it seasons, the market then picks it up or gets refinanced. Whereas in the ORCS it's more of what I'm familiar with from the I describe it as what the lever's loan

market was in the early nineties. There's more opportunity as a distress lender.

seeing just the overall fundamental picture for US companies. Are we getting the same amount of value for the risk that you'd be taking on or are you seeing you know, metrics like leverage or interest coverage starting to deteriorate a little bit.

leverage loans and direct lending. And that's a function of where capital formation is. So that's an important point. But in the answer your question, look, there are two ways to think about distress cycles. One is like an insurance company where you create ibn R incurb but not reported, like a reserve setup right top down. We know we're insurance company, we know we're going to have losses. Let's reserve for it and let's set up incurb but not report it, and then actually see how you are in

the reserve calculations. And that's one of the things I think direct lending, the BDCs and the clos haven't done a really good job of truck like an insurance company reserve concept, and I think if they did, I think that would bring a lot of sense of transparency and some level of security too underlying investors. So you wouldn't nessly have some of this heightened fear, right because people would have a concept of where they are in the

reserve analysis. But the other thing on the bottom up is at the end of the day, it still goes to the business model and the amount of debt relative to cash flow and where you're creating those businesses. And you had a private equity business that had so much money put to work they allowed peeing expansion or purchased multiple expansion, which don't make sense. I mean, if you buy something at fifteen times cash flow, you're never making a good return in your capital as a portfolio unless

it grows. So now you're in the growth business. You're in the private equity levered growth equity business, which gives you a very little balance sheet room to try to pull the levers for growth.

flow into their equity and bond pricing. But I'm wondering if you see that potentially starting to feed into other parts of the market.

I think it's about liquidity. When liquidity dries up or capital formation becomes difficult, it affects everybody. So if you remember an eight little lesson from the Great recession. The first stocks common stocks that you could see physically getting hammered with difficulty were small caps. Then it became smid caps, then it became mid caps, then it became little big caps, then it became big caps, and then it just became everything,

and it looked like you were climbing stairs. So I think the answer is keep your eye on the plumbing of the liquidity system, whether it's bonds or equity. To answer that question, gotcha.

again daily liquidity. So we have multiple products. Ultra short is a is a means, it's a category that means sort of if you don't hold cash, and you don't hold money market. What's an alternative with a little longer duration, right, a duration of one or less, And whether it's high yield or investment grades is a question of the volatility risk you're taking. So we have an ultrashort duration high yield product. People are, oh, no, it's high yield. It

buys bonds that have been called and redeemed. These are corporations that issue debt years ago. They go out and refinance. It's just like your refinancier mortgage, or they're going to come doing a year and they don't want to current live building in their balance because the auditors don't like it. So they're going to clean it up regardless of rates. So they announce they're going to refinance it, and they go raise the money to refinance it, and then they

issue a call. Okay, that means they're going to take you out. When they issue a call notice, they've structurally changed and stature chore changed their maturity. If it was a bond doing two years or three years and they call it, it's due on the call day period, they can't change it other than bankruptcy. That is the law.

So once they call it, you know it's coming out because they raise the money, right, so it's pretty safe and you gotta do some underrating, but it's a relatively safer way of investing in high yield as a cash alternative. And corporations typically have to give you thirty days notice, so it's if you're a pension plan, you don't want that. It's thirty day paper. Money market funds can't buy it because it's junk. It's got this sort of orphan opportunity.

Now would I buy called redeem paper of a nuclear power operator that has one plant. Let's say I'm three Mile Island for those who are old enough to remember, And the answer is, you're running the risk that the nuclear power plant melts down during that thirty day period or after they take you out ninety days later, because there's a preference period. It's one hundred and twenty day exposure. Yeah,

probably not. It's not a diversified business, right, so you still have to look at the business model and the risk. So anyway, that's ultra short. But you also do normal investment grade paper in ultra short, and then you have other products as well. But that's when ultra short category.

a big event. You know, the problem with being small is I had to joke, when you start as a small businessman, whether it's a money managering oils, you hire who you can with multiple tasks, not who you want to right, so your resources are more strained. Whereas a big firm you can throw money at problems. I'm not

saying they throw money smartly. So we just talked about SaaS, right, there was a big news that the block guys are firing, like I don't know, a third or half year, some huge number, you know, and there was a whole argument of oh, look what AI is doing, but there was other argument they were way over staff to start with. So, you know, I think really it's about how are you maximizing your resources? And then as you grow, how do

you transition? Because when you've hired the person who you could who could wear multiple hats, and now you've gotten bigger and you can hire multiple individuals for specialized tasks, what happens that person? How do you handle it?

with that comes risk, but also comes opportunity. And in our year end letter, we came out and we actually utilize some of the tools. I think of AI as like Excel. It's a tool, it's not a decision maker with Claude, because we kept thinking about the current administrative leadership in our country and where we are politically, socially and economically. As similar to the Gilded Age, and I really mean the Guild Age, but you could say it was the Golden Age of the fifties, but I don't

think so, more like the Guilded Age. Right. You can argue Twitter and sub stack and various things with publication as a form of yellow journalism. To put it in perspective, right, I mean, you could argue that there is a lot

of grift, like in Grift we trust. But you could also argue, you know, we're in an age of revolutionary change medically and computer wise, and we've been playing around with Claude to see, you know how much this helped Claude do the digging for us on how this mirrors and where there's similarities and differences in the Gilded Age. And actually I didn't get enough confidence level to say I was like in a like in a statistical way

that close of a confidence level. So we then started picking thirty five different types of environment in the United States, everything from the War on Poverty to the Civil War. And we started working Claude and saying, you know, where are we on a factorial basis with multiple factors, and where are we most similar, where are we different? And sort of how to think about it. And it's in our letter and we're gonna, we hope to put the work on our website where people can then overlay it

like a radar toocy where different environments matchup. We haven't quite gotten there because we're lacking the resources. But what's interesting is this came up as the seventh most uncertain period of the thirty five periods, only to be out beaten by In order if I think I can do this right off the top of my head, the number one I believe was the Great Depression. The number two was World War two. I think, the number three was

Civil War. I think the number four was the Great financial crisis, and I had my orders auto.

where there were crisis. We are not in crisis. I mean some people might think on the political left to right one crisis, but we're not in crisis. The key that got you into crisis was liquidity. If the market shut down from a liquidys standpoint, you went into crisis pretty quickly and it got pretty nasty. What makes this the seventh is not its amude in any one factor. It's that it has four factors are highly amplituded, and

no other period has more than three, usually two. The other thing is a requirement for you to go on crisis. Besides liquidity is income inequality or wealth disparity, and we definitely have that. So that was very interesting. And the key again was looking at what the capital markets do and how they're functioning. And I think the capital markets function well, and I think the world's pretty sophisticated, both emerging world developed world about that, barring balance sheets which

are getting out of control. I mean, look at Japan, right, The liquidity and the mechanisms to make sure the world's flowing is quite good and revolutionary. I mean, no matter what your views are on crypto, it definitely is a form of advancement toward keeping plumbing going. So I'm optimistic there, Sam. I think the problem is valuations are very high and we have a high degree of uncertainty. So I think you have high end volatility and as a result, we

position our portfolio right in voluntility. And what happens if we're wrong, we're just underperform, we make a little less.

You know? I think if the market takes a little bit of a turn, obviously duration becomes a big part of that. So do they focus more on that ultra short short duration? Look, or do you still think the Nordic view is kind of the spot to be? Where where should they be headed?

you missing? Some people are looking for wo volatility. I mean, I think that's the golden grayl high returns Novalla. When somebody discovers it, they probably found the fountain of life. Right, But and other people don't, and I think it's a very individualized or customized conversation. I don't think like the sixty forty year old clearly doesn't work. Right. So that's part of the problem in our world because we tend

to be conservative focused on the world. We tend to have on the extreme level of people running around the desert with a luminum foil on their hat head and on the less extreme version, there's still overweighted shirt erasure, right, because they're very value downside protection. So in those people, they probably don't have enough exposure for things where they can take risk five years out or longer and take

the volatility to get higher returns. Right. And then you have another group of people like, oh, rates are coming down. The government is very focused on reducing rates, which is true. I'm sure sure that's true. And the rates are gonna I think we're gonna have a steep yel curve. I

think real rates are gonna be high. I mean, if you think about the demand for money Gaza Venezuela, Ukraine, those aren't even those are those are drops in the bucket compared to AI, space, quantum computing all coming up all at the same time. The demand for capital in this revolutionary time is huge. That means you got to get paid to put your money out longer, which tends to mean a steep yel curve. I'm not the only person believes this. There's a lot of market strategies from

gaf Kale to to to others that believe this. But I mean, and that's it's just to me, it's reading the tea leaves.

on New Jersey, but South Jersey. You know, south of Philadelphia, south of Atlantic City, as far south as Baltimore, a whole different growing season actually, And I got into fish farming. I mean, the fact that the Nordic government thinks that they can tax fish farming is a is a scarce resource as a head scratcher to me, but they do. And I also was fascinated by the end of money. Right, places like Singapore and Norway have big wealth sovereign funds,

their currency should be strength. So back in two thousand and four I started thinking about it, and they and the Nordic has actually been an issue in the high yield market for a long time. I think Frontline Finance, which is a big shipping company, was one of Jeffrey's early shipping financings back when they just started after Druxil had blown up. So it's not like an unknown factor

is just not common. So what we found was is the Nordic high yield market I wold be specific, started growing, and they started growing because there wasn't a natural supporter of capital in that sub four hundred million dollar range. High yield issues got too big. Investment makans need to make too much money, right, so there was a void and when that void happened, the Nordic markets sort of stepped and said, we don't care if you're from Texas. I mean Forum Energy stocks on fire. It's in the US.

FET they issued dead in the Nordics. KKR is issued dead in the Nordics, and vest Corps issued dead in the Nordics. So you have LBO players realizing it's a source to raise capital. You have non Nordic countries, mainly German, and then the German sort of small borrowing range I figure what they call it, sort of disappeared. So it started growing naturally. And by the way, when markets grow a lot, there tends there can be some pretty bad underwriting.

I think Bloomberg has a couple couple columnists who followed the Nordic market and right up of all the bad ones. And that's true of every market that grows. But it's not a boiler room operation by any stretch. But in order to track money as a new issuer, you got to pay premiums. That's true in the United States too, So the whole market just started paying more premiums and was a smaller, so they're smaller deals, a lot more

new issuers, right, and you know, you probably are. I don't think you're giving up depending on what the circumstances liquidity. I mean, compared to Dell bonds, short you're giving up liquidity. But compared to most traditional high old issuers, I don't really think you are unless you won't have the issue. So, but they're smaller, you get them paid more. So we went over there. What I like about that space is they have property rights Anglo law, unlike places like Italy

in France who have who have ignored creditors rights. Even here in the States with GM, they've protected creditors' rights. They have a process that sort of helps prevent some of the credit on credit warfare that you see here. It's a pretty well established transparent system. Oh when they have secure debt, their floating rate, they're short maturities. Oh, when they're got covenants, something that the lever's law market. It reminds me of the lever's lawn market of the

of the early and mid nineties. So the risk obviously is that capital starts flowing out of there pretty quickly. And like when Ukraine got invaded by Russia. You know, we bought stalt Nielsen bonds. Really cheap, like one hundred and fifty bases points wider than they were the day before. It's pretty good because somebody couldn't hold dollar paper because they were European company, and we provided loquate. So you do have bigger movements when money moves in and out.

But it's a it's an interesting market. But you find stuff in the US too. I mean, you know in the investment grade side, tax liens, right, tax liens is a hedge fund business. They'd buy up the tax lines and then they pursue them, and you know, your tax liens first write on the property of a house. Well, that's now securitized er asset back market. That market's been growing steadily. We probably buy about three to four percent

of that market a year, just the idea. But it's it's typically single a double a kind of rated paper, and you're getting paid fifty to seventy five bases points more than the same equivalent rated paper.

else's backyard. And I think your mentality of an invited guest and welcoming help and assistance makes a difference. The other thing we did is I think if you're going to start investing a lot outside of your natural domain, you need boots on the ground. So we could put boots on the ground. What we did is we bought a twenty five percent interest in a what we think is a very solid credit shop in the Nordics called Norda Credit Investors NCI, and we own twenty five percent

of them. And we bought them because we're making decisions we're doing our own underwriting, but they understand common customs, personalities more familiar, and we do. We do consult with them regularly, but we're two different shops. So that's our version. Boots on the ground. Like we don't do any emerging market by the way, it could be an opportunity. We

just don't do it. It's not what we do. But if we did, we'd have to have boots on the ground in these locations if we were a significant investor.

ap perpectly. And you can just compare one year's certificates of deposit that are insured at a bank and a one year T bill is just sort of a measure or on the runoff the run te bills have been done, and it's particularly important credit because things change quickly. It's amazing how much more liquidity drives up and how much more premium you should have gotten paid. Two, I think people do not appreciate the kind of risk managers are

taking relative to what they think. So I think there's a lot of well known managers who take significantly more risk, even though their numbers don't show it. I think if you dig downlight on and by light on them, they're taking more risk than people appreciate. And three is I don't think investors are very disciplined, and you know that goes hand in hand with the risk. Right At some point you just have to say, like the Teddy Bears, I'm sure it's not gonna I'm sure it's gonna work out,

but it's just not for me. And if you buy it and you outperform me by fifty basis points a year for the next two years, that's fine. But when that Teddy Bear has a problem, if it has a problem, I catch up pretty quickly and then go back right because if you're down twenty percent, you got to be up twenty five to make it back.