(Ep.113) The Acquirers Podcast: Dan Zwirn – Modern Graham, Deep Value Global Special Situations, Asset, And Credit Investments

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In this episode of The Acquirers Podcast, Tobias chats with Dan Zwirn, CEO of Arena Investors LP. During the interview Dan provided some great insights into:

  • Modern Ben Graham Investing
  • Building A Buffett Style Money Machine
  • Deep Value Special Situations Investing
  • Control-Oriented Debt And Equity Investments
  • Bringing Your Own Weighing Machine To The Party
  • How To Find Special Situations
  • Creating Cheap Put Optionality
  • Over-Response In Liquidity Creates Opportunities
  • If It Doesn’t Surprise It Doesn’t Shock The Market
  • Fed Buying Mortgage-Backed Securities In A White Hot Property Market
  • The Greatest Way To Undermine Capitalism Is To Debase The Currency
  • Diversifying Insurance Investment Risk

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Full Transcript

Tobias: Hi, I’m Tobias Carlisle. This is The Acquirers Podcast. My special guest today is Dan Zwirn from Arena Investors. He’s got an updated approach to deep value that is absolutely fascinating. It’s a modern-day Ben Graham approach to markets right after this.

[intro]

Modern Ben Graham Investing

Tobias: Arena operates businesses as well, so how do you characterize Arena as an investor?

Dan: Well, we just characterize it as an investor. We are as comfortable as traders, as lenders, and investors, as well as operators and merchants. When you really look at who are the best true value investors, they are going back many, many decades. It’s people who are as comfortable with securities, as they are with operating. You look at today’s world, and you think about a Glencore or a Cargill, or you think about some of the large Hong’s in Hong Kong like Cheung Kong Holdings of Li Ka-shing and other folks like that, or you look at a Bola Ray or an Arno or folks in Europe, they’re trading, they’re buying and selling, and they’re owning and operating. It’s just another way to extract value.

In our case, we own 10 or 12 businesses now, where either opportunistically we had a chance to buy them at levels we’ve landed them and owned them for nothing. Or, in situations where we had to– we had a counterparty that couldn’t produce, couldn’t live up to its terms and so we ended up owning the enterprise. There’s opportunity there too. There’s another opportunity to allocate capital and look at the next marginal– at the margin, the next ROIC that makes sense, whether it’s buying another security doing another trade, or plowing capital into an enterprise that’s well managed, and well aligned with thoughtful skilled planning involved in terms of operating those enterprises.

When you see Buffett, or you see again, Li Ka-shing, or you see these folks, it’s all one thing. It’s the investment of that marginal dollar at its most optimized return per unit of risk. Being creative as an owner merchant can be helpful. Then also on the other side, being creative in terms of the capital you manage, which is a driver of the merger of the skills of managing obligations in insurance and investing. You see a lot of folks thinking about, like Buffett did decades ago, and like Henry Singleton and Teledyne did decades ago, maybe there’s pools of capital that I can use to do my merchanting and trading and investing that really optimize that kind of full capability, I have to optimize return.

Building A Buffett Style Money Machine

Tobias: How do you think about Arena as a hedge fund? You wouldn’t necessarily define it that way, you think about it in much more broad terms, even including something like Li Ka-Shing’s. Li Ka-shing is more of a trader, but clearly they’re investing as well.

Dan: Any student of value investing should look at Cheung Kong Holdings and Hutchison Whampoa. What’s incredibly interesting about that, as it is with Berkshire, is not any one trade or anyone holding. It’s the structure itself. Buffett has built– now there could be caps in terms of sheer size, but fundamentally, he built a money machine.

He built unbelievably cheap cost of capital, that put him in a position not to have to reach for the last dollar, to just look for a great moated franchise delivering a 10% unlevered yield. Put those two together, and it’s a money-making compounding machine. Li Ka-shing has done the same thing, and several other people have done similar things, whether it’s Koch Industries, or again, Cargill, or others, and it’s the structure itself. That’s what I talked about when I talked about thinking about Arena and putting that that value investing lens on Arena. Do you want to own arena as a stock, so to speak, as a business? Does it have a moated franchise and an ability to kind of create perpetual compounding value? That’s what we aspire to. Certainly, we are not that, but we certainly aspire to such things.

Tobias: How do you how do you achieve that structure? What’s the key element of the structure? The cheap financing, and then on the investment side, you’re looking for however you characterize the opportunity, 10% unlevered, free cash flow.

Dan: It’s really three things. It’s complete flexibility of mandate, so you’re not forced into a moral hazard corner. It is very proprietary, efficiently priced, hyperaligned sourcing of opportunity. It’s the creation of underlying infrastructure and capital formation that is scalable, and hyperefficiently operated. That means things like our people, our processes, our IT, how that works in order to kind of make it all come together as an enterprise.

Tobias: When did you establish Arena?

Dan: 2015.

Deep Value Special Situations Investing

Tobias: Before Arena, what was your focus as an investor?

Dan: Before and throughout Arena, it’s always really been the same, which is really the equivalent of deep value investing.

Tobias: Your structured convertibles, what is that for the folks who perhaps don’t know?

Dan: Well, I think just to step back, deep value is deep value. Whether that’s in a company or a piece of property, or a structured finance asset, or securities, and how you create that is just a matter of structure. Whether that’s a loan or buying an existing loan, or a bond, or a convert, or whether it’s public or whether it’s private, those are all just tools in order to extract and optimize return per unit of risk, within any given situation.

Structured private convertibles are an example of something that’s interesting that we do with public companies around the world that benefit from, frankly, situations that are more volatile, where the companies are the opposite of what you would look for, as a Buffett-style value investor. They may not have moats, they are capital intensive, there’s high volatility, there’s lots of things out of your control but in the case of the value investment going on there, is what we’re doing. As an example, those kinds of companies might be sub $200 or $300 million market cap, may not have otherwise available access to liquidity. We act as the casino, not the gambler, so to speak. Someone says, “Well, I have this stock that’s trading with decent volume.” We’ll say, “Okay, we’ll write you a convertible that converts actually at a discount to your trailing number of days trading pattern.”

Day one, we’ve created a cigar butt, so to speak. We’ve created a pretty darn certain spread, and we’re also given a quite a few out of the money call options, warrants of various sorts along with that. They then take those proceeds from the original issue that we’ve done, and they enhance their mine, they enhance their pharmaceutical project, they enhance their digital online, media oriented, whatever it’s going to be and that works out, great for them. If it doesn’t work out, not great for them. In either case, we’re going to make money. We’ve turned in that situation what otherwise would be a difficult to invest in situation into a Ben Graham style deep value, heads I win, tails you lose situation.

Control-Oriented Debt And Equity Investments

Tobias: Do you view these as– is it credit or is it equity or is it quasi sort of–? It’s a blend of both. How do you think about them?

Dan: Well, I think a lot of folks in investing think about couple things. Think about debt and equity as a binary, when in fact, it’s really a continuum of risk reward. Furthermore, they sometimes make the mistake of conflating what something is labeled with the risk they’re taking. We see plenty of situations where people who have a thing called a piece of debt but are taking equity risk. Conversely, we see plenty of situations where we might own a preferred equity or even a common equity, we’re very much taking a debt risk.

We only look at the underlying substance. In fact, the fact that that conflation occurs is an opportunity for arbitraged profits. In the case of structured private convertible, before we’ve converted, we’re actually senior to all the equity that’s there, the second that we do convert some or all of that, we own equity briefly, but subject to a locked-in spread. Then, furthermore, we own options, for which we’ve paid no consideration, which are just additional ups. When you look at the kind of payout pattern of what I just described, what it really does is get you an equity or more than equity-type return with a debt or less-than-debt-type risk.

Tobias: What does a typical borrower– why do they come to see you rather than say, going to a bank, given that you’re going to be requiring more onerous terms and some equity upside participation? Potentially plus, on top of that, warrants and options. What is it that Arena offers that a bank can’t do or a secured lender can’t do?

Dan: Yeah. Well, we frequently run into that question, because sometimes potential investors of ours say, “I don’t understand what that is, and I don’t know why they would do that.” [laughs] Frankly, at some point, that really dovetails into the topic of the degree to which your investment philosophy coheres with your entire philosophy of how things work, and how people operate. As a general matter, participants in markets cumulatively act in the same way, wherever they are, and whatever status or strata they occupy, and whatever time they’re involved. As a general matter, people want more than they have, from the smallest subprime individual customer to the biggest super high net worth person. We tend to find ourselves– what’s common about everything we do is that we’re dealing with folks who need the money, they don’t want the money. Because if you just want the money, well, then you’ve got all day long, you’ve got all the time you need. You can wait six months for the bank to decide they like the color of your eyes, or whatever they do. They’re not swift, to say the least, not only, in both senses of that term.

We see folks who have this need, and sometimes it’s offensive oriented, like, “I need to do this, because I think I can make a lot of money.” Or sometimes, it’s defensive, like, “I’m protecting my position.” That starts to create a process opportunity versus a value risk-taking opportunity for us. Sometimes, that’s because it’s geographic. No one wants to do Greece or Italy or Puerto Rico, depends on the country.

These days, we’re looking at things like Turkey and the Ukraine and wherever. As we say, we look at every house that’s on fire, and we stay in some. It could be industry, no one wants to do oil and gas. People have been burned by trade finance or things of that sort. Again, they’re running the other way, and we’re running toward it, because there’s always this overshooting. Then finally, there’s these individual situations where someone thinks they have a wonderful transaction, but it has this really tight timeframe they need to operate within. Otherwise, they’re under duress in some way and they need assistance and they’re willing to pay a premium, not for someone to take excess value risk, but to work faster, work smarter, provide solutions that others can’t.

Furthermore, the evolution of the alternative investment space has helped that along for us, because if you really map out that ecosystem today, there’s a systematic Pareto principle going on, which, as I’m sure you’re aware, Pareto principle meaning rising to the level of your incompetence. There are myriad investors out there filled with really smart people who are managing unbelievably large amounts of money, because they were good at managing that much less money, so why not have that much more money?

So, it’s really created a competitive umbrella under which we operate, whereby a lot of those great smart people really can’t get out of bed for less than a $100 million check. That leaves a big, big world of have-nots out there that need to be addressed. On the lower bound of the investment universe, then there’s really people who were basically hyperspecialized which, one, means that they can only do relatively few things, and almost ironically are inclined frequently to take more risks than otherwise they should, because they’re susceptible to the old hammer that only sees nails risk of only knowing how to do a very limited set of things.

We operate in that big middle, that’s getting bigger every day as that competitive umbrella rises every day. Even at our current $2.2 billion, we have the next step up where people are tending to compete on the price of capital is way off in the horizon for us.

Bringing Your Own Weighing Machine To The Party

Tobias: There’s a great comment in one of the Institutional Investor profiles on you, where you said something like, you don’t like to rely on the weighing machine of the market. You have two options, you either get repaid or you take control. Can you perhaps talk through that idea a little bit?

Dan: Yeah, I think that dovetails a bit with my comment regarding our being truly Ben Graham style deep value investors, which is that, for better or worse, folks who have been focused on value have tended, particular recently, to start to bring hope into the equation, and hope, we all know is not a strategy. They started debating value versus growth. “Oh, woe is me. Won’t somebody recognize my five times cash flow business and buy it from me for six times?” That’s very uninteresting to us. Structure allows us to not just identify value, but to extract value.

That means we’re effectively we bring the weighing machine to the party. When you have a maturity, it’s time for us to assess the value, put it on the counter, and either you’re going to buy back your asset or be able to refinance, or we’re going to liberate that asset from you and monetize it. Structure allows you to almost recreate the dynamic that Ben Graham did in in these net-nets, where you had as an example, a liquidating enterprise, which already said,

“Look, we’re liquidating.” We have the event, there’s no hope required, we think we’re going to get 10 to 12, it’s selling at 8, it’s going to occur over a particular timeframe. The weighing machine is present. But in so much more of what is referred to as value, there’s simply no catalyst, no hard catalyst.

People then seek to cure that through activism. From our perspective, we’ve never been big fans of that. Activism in many instances is just saying, “Please,” louder as opposed to simply dictating the answer. Structure allows us not to say please softly or loudly, it’s just going to happen. Whether that’s in a loan structure or buying a loan or creating a convertible or whatever. We keep things very tight in terms of duration, because duration has a cost and it’s frequently not compensated for in this market. Because the longer I’m involved, the more puts to the world, I’m short. So, I need to get compensated for that, and that’s not happening much. We’re going to keep duration tight, we’re going to keep structure tight, we’re going to isolate value, and then we’re going to be able to extract it. So, that notion of not being in a hope position is very important to us.

Tobias: I read, I’m not sure whether it’s an average or whether it’s the outlier, but you like duration around two years?

Dan: Yeah. Look, I think we like to think that we are as agnostic as it gets. We’re equally comfortable in a one-day trade, a two-year trade, or a five-year trade, or more. It goes to what I just said before, which is in this market, we simply don’t see duration compensated for so therefore, we’re not going to take it. Duration is a commodity like anything else, and if someone’s willing to pay, then we’re willing to consider it. Furthermore, I think we habitually delineate the duration of our principle versus anything else. We also like to say that we’re unbelievably patient once we’re playing with the house’s money. If my bait’s out at something, I can wait around all day. That’s just a question of discipline. In this market, I think you’ve got to be short, because the market won’t pay you to be long.

Tobias: When you say you’re getting your basis back, is that you’re getting the principal back, and then you’re retaining the options or the warrants, is that the–?

Dan: Optionality, however that might be defined, that can come in lots of different forms. It could be warrants, it could be royalties, but it could be things like– in several instances, we have found situations where there was a process wrinkle occurring. It appeared to us like the value was such that if we just bought the asset and the process risk was removed from it, it would be readily financeable. We bought the thing, and then within 90 to 120 days borrowed our entire bait out of it and owned it for nothing. That’s another way to kind of create that. When you have a free-flowing mandate, and are completely agnostic as to the instruments involved, and have a decent assessment of intrinsic value, you can put those tools together and put yourself in situations where you own a lot of free ups.

How To Find Special Situations

Tobias: You’re a special situation investor where you’re sort of creating your own catalysts and you have a very wide remit for how you execute that idea. How do you track down the investments? How do you identify them because these aren’t screenable opportunities, presumably?

Dan: That’s right, they’re not. Well, first, we know there’s a lot of them out there, because there’s– while capital is as cheap as it has ever been, these days, capital pays a premium for simplicity and homogeneity. We talk about this dichotomy between the haves and the have-nots. You’ve definitely got to turn over a lot of rocks. Again, thinking of putting the lens upon our own enterprise and saying, “Well, how would Buffett or Ben Graham view our enterprise? Do we have a franchise that’s moated? Is it sustainable? How do we gain edge? Is it leverageable? Is there operating leverage implicit in it?”

Leads us toward the notion of what we call joint ventures. Where we say, okay, we have among our investment teams, people with domain capability that’s monetizable throughout a cycle. But as part of those domains, there are innumerable things where there are particular wrinkles or particular opportunities, either by sourcing analytical or servicing capabilities, that likely aren’t going to be monetizable throughout a cycle but can be very episodically compelling. So, we will create joint ventures that are variable cost efficient to us, and where our partners are hyperaligned with our interests, i.e., they’re writing checks and we’re sharing proceeds in a way that can make them very, very happy when we’re pretty darn happy and very sad when we’re a little sad.

We effectively amp the ups and downs for them, which effectively incentivizes great conviction on their part or not. We control all the investment decisions upfront along the way. We control all the cash through our asset surveillance unit, Questor advisors. that allows us to kind of really open up the funnel, because instead of a firm with, we’re now 65-70 people go into 100. We have 200 or 300, additional folks who wake up every day go with their eye out for things that make sense on which to partner with us. That puts us in a position where we might be pouring through 10 plus 1000 things a year, to find 70 to 100 things a year.

Now, we know that from talking to potential investors, unfortunately, a lot of people say that. They’re really kind of mowing through investment banker books and such. When we look at opportunities, we look at them raw. If it already has a blue book in a good font, we’re probably not the guy. We talk to people and say, we don’t even need the deal. If you know two people who know how to do a thing really well, and they’re willing to cash up their personal net worth to go do it, I want to hear what they want to do, and what their edge is about. That allows us to have this enormous pipeline that we really can break into different permutations of industry, product, and geography.

It’s like being a fisherman with nets. We don’t know what fish are going to be in what net. Every day we pull them up and see what’s in there. When you see such a broad swath of industry, product, and geography, what you then tend to see is great dispersion when thinking through return per unit of risk. We see things that are kind of obviously good on a risk reward basis, and really, things we want to run at. We also see things that are obviously bad, and we tend to see things that are obviously bad before the warning bell has come on this. In certain instances, we say, “Well, can we create cheap put optionality?” Or, “Can we be short this in some way, asymmetrically to take advantage of this kind of really awful return per unit of risk we see?” [crosstalk]

Creating Cheap Put Optionality

Tobias: Can you give an example of both of those sides, about how you’re identifying a better than average opportunity, and how you’re identifying something that you’d rather write the put on or buy the put on?

Dan: Sure. As an example, we have a wonderful business in Korea doing a form of structure private convertible kind of culture back lending that’s very interesting and lucrative. That’s a small world of folks. We’ve been operating there for many, many years. There’s pretty good risk reward built into the structures of these emerging companies there that are pretty favorable. We see it and we see it over and over again, as an example. On the other side, we see things like what’s going on in leveraged loans, which are fueled by the fact that no one’s taking the risk, because they’re finding their way into CLOs, the right side of the balance sheets of which are way too tight and are effectively pushing risk into other people of various sorts. We say, “How do you create cheap put optionality there?” That could come from things like different combinations of securities that you’re long or short, to create effectively a carry, or that’s at least neutral that allows you to wait for something to explode, either idiosyncratically or kind of on a larger semi-systematic basis. It could mean things where you see sovereigns, where the actual intrinsic state of their economic affairs are horrid, but they’re able to borrow at negative rates, like certain parts of Southern Europe.

You say, “How is that not a value trap? How is it silly in position and to continue to be silly?” Well, then the challenge is not only is it silly, but how do I create asymmetry there, so I’m not in a position where as they say the market can be irrational longer than you can be solvent. Setting those things up to create optionality on the put side versus the call side is something we think about.

Over-Response In Liquidity Creates Opportunities

Tobias: The last 12 plus months of being volatile, we’ve had a huge drawdown, and then we’ve had this absolute flood of liquidities. How do you navigate something like that? What does your opportunity set look like as you go through that big drop, and then the flood of liquidity on the other side?

Dan: Well, I think we start with an analysis of what are the secular changes that came into play with COVID when you contrast that with ‘08, 01’, ‘02, ‘98, or ‘94, etc.? 2020 is rare. It’s not that it’s never happened, but this much ubiquity of availability of liquidity, this much agreement among sovereigns, both in the monetary authorities and the governments themselves, to act a certain way in response to the world really hasn’t happened in centuries. That’s interesting. You’re seeing basically all of the world’s monetary authorities and governments comfortable utterly debasing their currencies. Ultimately, whether you believe it or not, the notion of cryptocurrency, as an example, is really like a voting machine on how much we all think badly of all of our developed market currencies. We may differ on the degree to which we think some of those currencies will be legitimized or are legitimate, but that vote against the intrinsic value of dollars, euros, yen, etc., is pretty strong. There’s a reason for it.

So, we have this massive excess liquidity, this massive over-response, the massive overreach of government. That has never failed to create volatility and havoc, just never. Whether you look at the Great Society, and Vietnam War era of Johnson, you go back to pre-World War II, Roosevelt, you go back to the implementation of the income tax in Wilson, and even the desire for it, and Cleveland and so forth, or even the UK with the disaster of the Wilson government, every time government reaches out and just gets itself involved in things, it grotesquely misallocates capital, creates all kinds of different arbitrage opportunities and havoc. We think that is the backdrop.

Again, we’re not macro investors, I don’t have a view as to the timing of any of these things, but it’s demonstrably bad. So, we like where we sit in that regard because we’re kind of neutral to all of this. Other than we need change, we need people to really dislike something or really like something, because either way they overdo it. This kind of situation leads to lots of overdoing and underdoing of things. It creates opportunity for us and what we’ve seen it’s happening sequentially. Different pockets of opportunity are coming available. You saw that with travel-related things, and you’re seeing that with business-related accommodations and travel and things of that sort. You’re seeing people who are amending, extending, and pretending. You’re seeing throughout the credit markets, access to liquidity in the absence of solvency.

So, always the greater fool there to take you out of your problem. The moral hazard bubble growing and growing, the complete unwillingness of monetary authorities to acknowledge the inflation they’re creating. That’s going to open up more and more. Particularly as COVID is solved, there’s a ton of different actors in the market who have said, “Well, if only COVID was over, all would be well.” Never mind the tremendous secular changes in the way we all live and do business that will create really a lot of different secular changes that will have to be responded to. We’re going to be beneficiaries of those who hit the wall. We’ve also been beneficiaries of those who are taking advantage and playing offense and building and doing and creating things that will benefit from this new existence that we have. So, lots and lots to do, lots of change coming.

Tobias: I know you just said that you’re not a macro guy and you don’t have any idea as to the timing but let me ask you anyway. You’re clearly a student of history of the markets, how do you see something like that potentially playing out?? Is it months? Is it years? Is it decades? How long does it sort of take for the toll to be paid?

Dan: Well, part of it depends on how much of this stuff sticks. In the US, which is always the driver, or not always, but certainly is going to be a major component of what happens, there’s a lot of reasons to think that this kind of mini-boomlet of post COVID, will carry the democrats through the midterms, which will create all the more likelihood that a lot of this stuff sticks. Historically, no matter if a conservative government later comes in, once a nation state’s government gets its hands on more power and more resources and more dollars, it’s like taking steak out of the jaws of a lion. It’ll be very hard to unwind all that kind of bad policy, no matter who comes in. At that point, is that by ‘24, where you start to see that? It could be ‘25. Part of the issue is you look at Japan, and what they’ve said is, “Look, it’s never going to end. We’re going to take the problem we created, and we’re going to just smooth it out into the perpetual future, by always being there with more liquidity ever and ever and ever.” You could very much have this notion, this kind of malaise effect that just stretches out.

In the US, that was late 60s to early 80s, as an example. It took years for– when you look at the Wilson government in the UK, took years for that– and a lot of pain for that to be shaken off of the UK. Could you start to see effects of this in ‘24, ‘25? Certainly could. Not many things are harder than being a successful macro investor, and I’m certainly not one. We just want to be there. Again, we want to be the impartial arbiters that are, again, the casino, not the gambler, and be a beneficiary of the volatility that we created from it.

Tobias: That period from the late 60s through to the early 80s was one where the stock market really did nothing with a whole lot of volatility in the interim, and since the 80s, we’ve really had this extraordinary bull market. It’s had its ups and downs, but it’s also– we’re at all-time highs now. Do you see there’s some sort of Minsky moment coming? Is this something likely in that?

If It Doesn’t Surprise It Doesn’t Shock The Market

Dan: Well, I think when you look at historically, there are these moments and they’re triggered by something we all don’t think as likely, because if it doesn’t surprise, it doesn’t shock the market into acting. When WorldCom announce its fraud the first thought was for us was, “Thank goodness, we’re not in that,” because there were people in near term [unintelligible [00:39:01] at ‘92, that it was rating at 10. Then, there was very quickly a tidal wave of leverage loans and credit coming over the sell side [unintelligible [00:39:13]. Certainly, these days, you look at someone smart, who thinks about left tail events like a Byron Wien, and you think about things like China invading Taiwan tomorrow, because if they decide to do that, no one’s going to stop them. That could be shocking, or it could be so overwhelming and over in three days, that maybe it won’t. Or, certainly, what we’ve seen is– what’s interesting is, we’ve seen wherever there’s even a little bit of a shake in the markets, Jerome Powell and other monetary authorities and governments themselves– they don’t even let the stock market move down a little bit before they come out and say, “We’re going to do everything. It’s going to be okay. Please don’t.” It’s got to really be a shocking thing that’s going to break through that kind of stuff. But for that, I think you’ll see there’s a lot of chances the markets will move up, at least in nominal terms. Yes, the S&P is X, but it’s X in denominated in these things that whose value is declining by the month.

Fed Buying Mortgage-Backed Securities In A White Hot Property Market

Tobias: There was a question yesterday and press it to Jerome Powell, I thought it was revealing one, I thought it was a good one. One of the journalists asked, “The property market is wide hot at the moment, residential property, very, very hot. Yet the Fed continues to buy $40 billion of mortgage-backed securities every month. What’s going on? Help us connect the dots.” He gave this very evasive answer that I thought was revealing in the sense that they’re managing to something else, they’re managing it, and possibly it’s the stock market, but they’re not managing that individual risk at all. They’re not thinking about that one at all. Do you have any thoughts on what the Fed is doing?

Dan: Well, certainly in the middle of March 2020, we saw them basically communicate that they weren’t going to let investment grade credit go down. Why would that be? Well, there’s huge exposure on the part of banks, insurance companies, pensions, massive, massive exposure. I would suspect that– let’s say you take the average life insurance company that has $1 of equity for every $10 of assets, and 85% of its assets need to be an investment grade credit. That investment grade credit might have been making a couple percent with a four-year duration. If that spreads out 200 basis points, the reduction in the equity of the entirety of the life insurance business is massive. That’s one example. Unfortunately, because of the bubble that was blown up in the 12 years between 2008 and 2020, there is nowhere to go. There’s nowhere to go other than to just dig deeper or make the bubble bigger.

Again, people’s lust for residential real estate is no different than their lust for cryptocurrency or anything other than that, which is denominated in USD. Particularly among even retail where I’ve had people say, “Well, as a retail investor, what should I do? What should I buy?” I’m like, “Well, I would buy– I scraped together enough dollars to borrow super cheap and buy a four-unit multifamily apartment,” because there you have an appreciating asset that’s providing yield, that effectively mitigates the damage that this activity is doing to all people who responsibly save. It’s remarkable how willing the monetary authorities are to keep this going. It’s unfortunate. It takes a lot of pluck to be Volcker 1.0. Say, “Look, this is insane, but if we’re going to do things for the long term, instead of just pushing problems into the future, here’s what we got to do.”

Tobias: What’s the end point to that? It clearly requires some sort of political will to do it, there’d been absolutely no reason why any government globally would do that when every other government is printing, because I assume that the moment that you do that, you’re going to see a collapse in asset values in your own economy. How does it resolve itself?

Dan: Well, there’s overwhelming political will, it’s just to do the wrong thing.

[laughter]

The Greatest Way To Undermine Capitalism Is To Debase The Currency

Dan: Because that’s good for getting votes. There’s a wonderful book on Walmart Germany that in the preface of which quotes Keynes, in turn, quoting Lenin, basically saying, “The greatest way to undermine capitalism is to debase the currency.” Then, Keynes saying, “And the greatest thing about that strategy is not one man in a thousand understands that it’s happening.” When any kind of extreme, extreme borrower gets way out over his or her skis, if he or she can pay back in depreciated currency, that’s the greatest. If you’re a politician looking at the next election or a monetary Mandarin looking to boost your resume, this is great, just keep printing, printing, printing, printing. Then hopefully you’re retired or you’ve moved from the legislature to the governor, the governor to the next or the back to the private sector, then it’s somebody else’s problem.

Tobias: Given that, it sounds to me, you think that there’s a great deal of risk out there. There’s a very visible reef underneath these waves. How do you protect your investors– you referring earlier to seeking diversification across geographic? I’m sorry, I missed the other two, but–

Dan: Industry, product, and geography.

Tobias: Can you just explain that a little bit? Does that assist with the protection?

Diversifying Insurance Investment Risk

Dan: Well, there’s two key parts of protection. One is that diversity. Let’s say you’re a property and casualty insurer, you don’t want to write just a huge amount of risk for a Japanese earthquake. You want to do earthquake, and you want to do tsunami, and you want to do all kinds of other different types of bad weather things, and then you want to do them all over the planet. You want to spread out because anything can happen anywhere. I want to have as much diversity, not just by number of positions, but by the lack of correlation amongst that which happens to each of those permutations of the notion of orthogonality. As much orthogonality as possible. That helps us shield ourselves from those kind of lightning strikes that happen so that we’re not then on the next day’s Wall Street Journal talking, about, woe is me, it was a 100 years’ flood or whatever, perfect storm.

The only thing that is sure about perfect storms is they keep happening, so let’s spread out and not use that as an excuse. Separately, there’s this notion of structure, and in this case, subordination. Again, no matter what instrument I’m in, whether it’s a piece of debt, or equity or whatever, I’d like other people to lose money before I do in any given investment, ideally. Again, the casino operator is just standing there waiting, someone comes in and they’ve got their chips. Casino operator knows 92% of the slots, I win, or whatever the percentage is. 58% of the blackjack hands, I deal, I win. So, I just keep dealing and dealing and dealing, but the odds are in my favor.

In our case, when we have a portfolio of investments where on average, there’s 30 or 35% subordination, there’s value underneath us, real checks being written, that needs to be eviscerated, before our value is touched, that gives us real margin of safety. We’re really focused on that notion of where we are in the risk stack. There’s a continuum of risk reward in any given investment we’re at. You combine those two things. Hopefully, it’s going to be really hard to lose money. Still not impossible, but we want to be the last man standing, if possible.

Tobias: What does the future hold for Arena?

Dan: Well, we’ve got a ton of wood to chop. We’re working building on all of those things. We’re hiring quite a few people in our operations area in Jacksonville and in a new place we’re opening in India. We’re building our processes and our IT better and better and better. We’re adding more and more joint ventures. We’ve really planted our flag sufficiently for now in our main kind of theatres of operation, North America, Europe, Asia Pacific, and Latin America. We have that base platform. There’s a lot of building to do. We’re working very, very hard, because we see this opportunity coming in the environment that’s going to be unfolding over the next many years, and we want to build an infrastructure in an enterprise that can most benefit from that environment.

Tobias: Dan, it’s absolutely fascinating. If folks want to follow along with what you’re doing or get in touch with you, do you have any suggestions how they might go about doing that?

Dan: Well, we do have a– we are partners with a public company in Toronto called Westaim Corporation, which trades on the TSX. Westaim has a very developed website, as do we. They and we effectively report quarterly. We have sell side research coverage, and we try to be in touch with thoughts to shareholders, to hopefully communicate our vision to them, as well as the investors in our funds. There’s a decent amount out there. [Twitter: @dan_zwirn]

Tobias: That’s fantastic. Dan Zwirn, Arena Investors, thank you very much for your time.

Dan: You’re welcome. Thanks for having me.

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