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9Questions is our Q&A series featuring key decision-makers in leveraged finance — get in touch if you know who we should be talking to!

Dan Zwirn is the founder, CEO and CIO of Arena Investors, a credit-focused asset manager that provides capital for special situations, including private corporate and asset-based lending, real estate and structured finance. 

Arena has become a $3.6bn global investment firm focusing on special situations asset and credit investments in corporates, real estate, and structured finance.

He spoke with 9fin about how tighter borrowing conditions are starting to cause trouble across leveraged finance, direct lending and structured credit, and why flexibility is a key pillar of Arena’s lending strategy.

1. Low rates and support from the Federal Reserve created easy financing conditions for highly leveraged borrowers in credit markets since the pandemic, at least until recently. You’ve described this as the “amend, extend and pretend” phenomenon. Now that rates and spreads have widened, which areas of the credit market are you most concerned about?

We're finally starting to see some action, even though intrinsically credit has been very poor for several years, because of this unbelievable amount of bubble-oriented issuance. You've seen across the first few months of 2023 we've had the greatest level of bankruptcies since 2010, as you saw by the recent note from S&P.

So much of the assets that are out there, particularly in corporate credit, are in floating rate loans versus high yield. So suddenly, even in the absence of material widening and spreads, there's material diminution in interest coverage, which then starts to precipitate rating changes, which is what large scale real money accounts actually have to pay attention to.

You then have this ecosystem of interconnected areas across middle market, private equity, leveraged finance, direct lending, and CLOs. All of that is about has been driven by the availability of terribly underpriced CLO equity that’s been willing to be owned by people not managing the CLOs — completely disconnected from an alignment perspective. 

Now that's starting to come home to roost. It’s getting harder to get that external CLO equity, it’s also harder because of rising rates to get the triple-A debt at virtually no cost, so it’s harder to close CLOs, there are fewer bids for refis, and the avenues for getting out of what should have been a problem have been materially reduced.

There are analogues in structured finance in the conventional hedge fund oriented areas like in aircraft leases; again, credit spreads are increasing, the quality of collateral decreasing, and problems arise. If you look across the structured finance universe, unsecured consumer, auto, residential mortgages — all of that credit quality is diminishing. More and more delinquencies are showing up every day.

And then finally, in real estate you have all of the issues you had with corporate debt further exacerbated by the secular changes associated with work from home and originally COVID. The little tip of the iceberg is these very big name sponsors finally defaulting on the poorest of office space that was in real harm two or three years ago.

Then there are things like venture capital kind of imploding which has meant new types of credit opportunities. Credit may come in and replace what otherwise would have been very punitive down rounds from large scale venture capitalists. There’s a whole series of adjacent opportunities that are arising from this implosion in these big three credit markets.

2. Are there any reasons the Federal Reserve wouldn’t provide that kind of support to credit markets again and keep the party going?

They can't. Because if they don't create positive real rates, there's no way to dampen inflation given the government’s profligate fiscal indiscipline. It's just math. They created this massive asset bubble that has only in the very slightest sense begun to elapse.

Monetary authorities are in a position where if they don’t want to be viewed as Arthur Burns, they have to keep rates up. Bernanke, Yellen, Powell, Lagarde and Draghi caused the largest asset bubble ever, and so there's a real interest in keeping rates up to kind of diminish that.

In the case of governments, they want to find the votes of voters in the next election. So therefore, they systematically overspend. Those two things run counter to each other.

Collectively, what you get is a combination of the greatest level of both rates and inflation possible that markets can stand without creating either rampant hyperinflation or extreme recession — if not depression. Running inflation high allows them to gradually reduce the debt owed by virtue of this massive over-borrowing. 

So this notion of being saved isn’t going to happen. We're in a position now where there's no room to do that anymore. But markets are now conditioned, which is a classic moral hazard — to believe that every time investors have a problem, they're bailed out.

3. In the early 2000s it was dotcom and fiber companies, in 2007-2008 it was real estate debt, in 2014-2015 it was oil and gas. Which sector of the economy is going to be at the heart of the next capitulation in credit markets?

I would pick enterprise software. I created one of the earliest franchises doing enterprise software lending. The opportunity set was that banks weren't recognising the razor and blade nature of enterprise software. 

If you've ever been associated with the implementation of an enterprise software system, it's the worst thing ever to rip it out. It's a really sticky razor and blade. That’s why everybody hates their latest software enterprise software provider just less than the last airline they took a trip with. The issue is that became widely recognized, and systematically overpaid for.

If you have a recession, or your margins diminish, you're going to have customers going out of business, or not willing or able to change software providers, you'll see that cashflow move down, multiples move up. You'll see debt service reduce, and many of these are heavily leveraged businesses — the original loan to value was created by this massive overpaying for the business.

Furthermore, you've seen a number of people take businesses that are intrinsically not razor-and-blade software businesses, and try to jerry rig them into something that looks like that in order to get premium valuations. So if I had to choose an area that was really grossly over done, despite the fact that intrinsically there are real enterprises there, it would be that.

4. Private credit is taking a bigger share of the corporate leveraged finance market, and it’s also making inroads into private asset-backed securities — what will be the impact of this increasing privatization of debt markets?

I know people try to make this distinction between broadly syndicated and not. But the reality is those two kind of intersect. If there was a systematic difference in their return to risk, capital would flow to one versus the other. They've kind of met each other in the middle. So does it matter? 

Maybe the leverage on direct lending is lower, which is probably the biggest reason why it's arguably safer. The people who are the direct lenders tend to own the equity in the structures of the financing, whereas the managers of CLOs literally have no skin in the game. They have negative skin in the game. 

So it arguably could be more safe. Also, loans made now are getting more conservative, because they’re priced in today's environment. 

The real trick is the majority of the people who are touting that as an opportunity themselves were wildly prolific lenders when it was a horrible thing to do. And no one seems to be reconciling that. Are they ever going to tell you it’s not good? The answer, of course, is no, because they’re a hammer that always sees nails. 

5) How have your previous experiences in finance influenced the way you run Arena?

It's pounded into me the number one reason people get killed in our world is moral hazard. And hammers that only see nails ultimately get killed. 

Lending is the world's second oldest business. There's nothing new about anything going on in direct lending. Banks have blown themselves up doing it, insurance companies have blown themselves up doing it, direct lenders will blow themselves up doing it. That’s the number one thing.

In our markets we have dozens and dozens of different permutations of industry, product and geography that have their own frequency and wavelength. At any given time, there's always stuff to do. But when something's horrible to do, you don't want to allocate from 7% to 5%, you want to go to zero. But a lot of funds are set up so that they actually just do a little less of things that are horrible, which makes no sense.

6) How does Arena differentiate itself in these increasingly crowded credit markets?

There are three things that are at the core of our competitive advantage. 

One, we're not a hammer that only sees nails. Our investment mandate is only to optimize return per unit of risk. Fifteen plus years ago, I created one of the five largest franchises doing what is now called direct lending in the US, but then it became far less compelling. Within lending, we were doing non-sponsored, or oil and gas or venture lending for things that included some level of structured finance or real estate in combination with a corporate risk in order to avoid the sponsor market. Now we're starting to kind of cycle back to some of that. 

We can do a large number of smaller transactions, to stay away from the big guys. All of our investment types compete with all the other ones — I'm not shilling for any given product. We have North American corporate, real estate, structured securities, natural resources, secondaries, liquidity solutions, European private and Asia Pacific private, all investing from one pool, all competing for capital. If we don't do a direct loan for the next three years, it doesn't matter to us if it's not good risk reward. That's totally different than 99% of asset managers.

The second is that we have proprietary sourcing. We get virtually nothing from investment banks. We have another 40+ joint ventures with people who are exclusively connected to us who do very specialized things, whether it's small-scale music rights or liquidating aeroplanes or buying non-performing loans in Indonesia or whatever it might be. 

The third is servicing. In the last 14 years, people have systematically under invested in servicing, workout, operational improvement, etc, from a creditors perspective. We have our own associated servicing advisors, where we do surveillance and servicing and workout plus our associated operational improvement [advisor] Questor Strategic. We're also doing this for third parties, because people have so systematically under invested in these capabilities.

7. The growth of private equity is being fueled in part by their growing partnerships with insurance companies. How do you see these relationships developing — and what risks do you see developing further down the line?

The relationships with insurance companies have fueled the growth of large-scale alternative investment platforms that in their first incarnation were private equity firms. 

The reason they moved toward insurance was because of their captive assets. Originally, a number of those firms approached the notion of doing that with banking. But it was so over-regulated and badly regulated that they kind of couldn't manoeuvre sufficiently. 

So they went to insurance because there's a lot more variations of what an insurance company is and how it’s regulated. That gives a lot more leeway to get assets onto the balance sheet. The majority of those partnerships you're talking about have been focused on fixed annuity. That was because when rates were super low, the cost of your liabilities would be really, really cheap. 

The risk there is rates are now moving up. The cost of originating those assets is much higher. It’s a very big deal when in 2018 the entire cost of your right side of your balance sheet might have been 4.5%, and that goes to six or six and a half or 7%. There are still relatively strict standards in terms of the amount of capital you have to put against each obligation. 

So when the cost of your obligations moves up as severely as it has, it’s again a case of moral hazard. You're pushed to get assets out, so you can outrun that. 

That's been exacerbated by the fact that insurance companies don't have to really take marks — meaning if they have a bond that is still performing but drops 20 points, they can take the interest on the coupon entry into the income statement as earnings, but the 20 points unrealized loss only goes to the balance sheet. 

It's a really compelling area. The combination of insurance with investing and fixed income investing makes a ton of sense, but it can get abused. Very few people have combined those two at scale in the way that some of these new agglomerations of managers have, other than Buffett, who's Buffett!

8. When and how will commercial real estate debt markets adjust to the reality of hybrid working? 

We're out there buying distressed debt directly from banks and insurers now. We're looking at refinancings of situations where people are now assigning much higher cap rates. With regard to work from home, you're seeing a lot of really, really ugly stuff within office. 

If you're looking at Manhattan, any office building built before 2010 but capitalized subsequent to the GFC when rates were really low has no equity value and an impaired debt structure.

Initially [during the post-Covid recovery], you saw people jerry rig free space and tenant improvement capex and other things in order to announce a headline lease rate that was way higher than it really was. There was a lot of this obfuscation for a while, there was a lot of amend-extend-and-pretend activity, particularly within securitizations and special servicers. 

Most recently [borrowers] are saying ‘don't worry, we'll turn it all into apartments’. Except that, structurally, the way the space is apportioned doesn't really work that well. To get to where cap rates would be for a multifamily apartment building — if you work the math backward based on how much capital you have to put into it, how much dead time you have to have for the building, plus the zoning — what you’re talking about is buying the securities at pennies on the dollar to make the positioning of such a building make sense.

That's beginning to roll through. And that's on the good side. You're seeing things like suburban office, or even the Scandinavian transaction that just busted for Blackstone — there's certain office space just it has negative value. It's economically impossible to retransition it to something else. The best you could do is demolish it and make something new. There's just a lot of space that’s going to have to change. In some ways it'll go through something equal or worse than what happened to a lot of the malls as a result of e-commerce. 

So there's just enormous changes that have to happen and that and that has only started in the slightest way to ripple through. 

9. What’s the best book you have read recently and why?

The Story of Russia, by Orlando Figes. It's obviously timely given what's happening with Russia and Ukraine. It gives you a sense of why each side is so ambiguously confident of its position. And how each of those positions is not really well supported by facts of the matter. It talks about the 1000 year battle between various factions in that world, and the notion of tracing back whose land it was unambiguously.

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9Questions — Dan Zwirn, Arena Investors

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