David Sherman (00:03:02):
My clients was an easy sell, they wanted more yield. But it seemed kind to stupid to me to do a static high yield portfolio, knowing you were going to have losses. And just like an insurance company has to predict future losses and a property [inaudible 00:03:16] for incurred but not reported, you knew of this was going to happen. And the question was, how do you get rid of, or how do you minimize the risk of incurred but not reported losses? As a result of doing work and networking, I was fortunate enough to be offered an internship at Drexel Burnham in LA working on Milton’s trading desk.

David Sherman (00:03:33):
And that obviously by [inaudible 00:03:35] through a young college student, right into the heart of high yield, right as 1985 and 1986, it was the beginning and it was super exciting. It’d be like being in the forefront of the crypto investing today. And I got lucky, good space, very well, great mentors, great opportunity. Came back to St. Louis’s during the school years and created the investment banking client list and saw that one of the clients was an insurance company owned by a company called Leucadia National, and I decided that they were able to get me an internship as an analyst junk bond analyst. Again, more being focused on junk, I ended up joining them full-time, my senior in college.

David Sherman (00:04:16):
Leucadia has a great reputation among value investors, and that was a great place to learn under Joe Steinberg and Ian Cumming. I stayed there for 10 years, left as a senior executive. And there, I got the experience of not only managing junk bonds and looking into junk bonds, but looking at distress junk bonds, looking at stress, junk bonds, looking at deals and transactions that are actually investments, taking insurance company assets, and understanding asset-liability management, investment grade, asset-backed securities, mortgage-backed securities. And interesting things we don’t even talk about today like dual securities, where they paid your principle in US dollars and the coupons were in Swiss francs.

David Sherman (00:04:55):
And I was got to be exposed to all this, I was the treasurer of those insurance operations as my line responsibility. Even going out to Russia, early days in ’94 with vouchers. So it was a great place to learn. And I was fortunate that I put education and learning over making money. I did perfectly well in Leucadia, but I could have gone on Wall Street, had a very narrowed vision and not extended it, but I stayed with high yield because if you look at high yield, whether it’s distressed or stressed or high yield, the entire area is intellectually interesting and it’s not well followed.

David Sherman (00:05:31):
So just like a good value investor, it was less crowded in those days. You could find better opportunity if you were good at getting information by digging and also doing research. And if you look at the general high yield market, historically over 10 year periods of time, the high yield market has produced quite similar returns to the equity market, slightly less, but quite similar with significantly less volatility. So it’s sort of hybrid equity, which would explain why firms like Oak Tree were very attracted because it gives you very good risk volatility or risk-return analysis or a better [inaudible 00:06:06] So I just got lucky and I’m a curious person and it piqued my curiosity.

Trey Lockerbie (00:06:11):
Well, you touched on mitigating the risk. I’m really curious about that. You’re walking into a company that’s distressed, as you mentioned, and they’re putting up this high yield because there’s a lot of risks involved. And so what do you typically do to mitigate the risk? And do you see any activism involved in this space at all, where it’s like, okay, we’re going to invest in this, they’re in a tough spot, but we know we’re going to turn it around, and just talk us through the diligence around that?

David Sherman (00:06:38):
In that question, I think you need to break down high yield from the stress and distress market. So think of the stress and distress market as a credit opportunity, think of high yield as money-good paper or paper you believe will be money-good, where you’re clipping coupons and you’re clipping returns significantly higher than the investment-grade world or other fixed income. So in the high yield world, quite frankly, in financial analysis is the key to mitigating risk. Today you could overlay and put hedges on using CDS, CDX. These are derivatives on the index or specific credits or specific companies. You could even just as simple as buy puts on HYG, the ETF, or short HYG or JNK.

David Sherman (00:07:23):
The ETF world has been great at segmenting asset classes to allow you to have access to these things. But then you’re hedging away, broad-based market risk. A lot of people can’t do that, takes a lot of capital, and then you’re getting a lesser return. At the end of the day, the best way to mitigate risk is to focus on protecting your principle first, which means you have to be a bottom-up high yield investor, unlike investment rate or treasuries, where you’re making big macro decisions of is the Fed this week in Jackson hole. This is going to podcast in the future, but are they going to raise rates? And where’s the shirt rate going to go? And what’s the curve going like?

David Sherman (00:08:00):
In high yield, you’re getting most of your return by picking the right credits. So it’s much more akin to being an [inaudible 00:08:06] and the good news is, unlike ECBI where you can easily lose all your money because you’re the bottom-up capital structure, here you have some protection so that if your analysis is off or management fails to execute, you have some cushion. It may not be enough, but you have some cushion. In return, you’re giving up unlimited upside, obviously. Like you are top in the capital structure depending on where you are. So a high yield investor, it’s really their understanding of the business model and also doing the analysis.

David Sherman (00:08:37):
And I think the business model is really important. Now, companies either become distressed that were investment grade or they’re high yield and they become distressed. So the best-case scenario to find a stress or distress investment if you’re a value investor, is to find a company with a great business that has a bad damage. So examples in the past are, for instance, RJR Nabisco that was leveraged buyout by KKR. This is one of the oldest greatest ones that people talk about. Just too much debt. Great business, too much debt. So the question was, how do you compromise or mitigate the capital structure, the debt structure, and who are the beneficiaries and where do you want to participate?

David Sherman (00:09:15):
So a distress investor really, really is an equity investor that uses the bankruptcy laws to help determine the rules of engagement. Some people focus strictly on making money by taking advantage of those rules of engagement, as a hedge fund quota really is, it’s extremely good at this. Lately you’ve read a lot of articles about hedge funds being on the steering committee or the inside committee to cut a better deal for themselves by putting up new money, help the company come out to bankruptcy to the detriment of other bondholders that they’re equal within class, but in general, there’s still rules.

David Sherman (00:09:49):
So you have to really understand a mass of those rules, no different than if you’re a Congressman, you should master Roberts schools of order. And then you have to do a basic analysis. And again, a bad business, you can’t say. I don’t particularly like the steel industry, not because there’s anything wrong with it, but it’s got capital intensive, commodity-driven product with generally a lot of leverage. Those aren’t really good business models. And if you’re going to do it, you want to buy it when it’s the cheap stock going into its cyclical upswing, but to be a lender, not so great. So another example would be nursing homes. Again, high operating costs, big expenses building it.

David Sherman (00:10:30):
You have the government, meaning Medicare and Medicaid, basically leading the price, saying of what you get paid for reimbursements. And if you do an excellent job, best of care, they reward you by capitating your pricing. So I think understanding a business model is important. Now as a distress investor, taking that nursing home example, if you buy a nursing home at $20,000 a bed, you’re going to make money, right? You’re buying it at a cheap enough if it’s a well-run nursing home. So I think there are two different parts.

David Sherman (00:11:01):
So I don’t think it’s a coincidence that distressed investors or distressed firms became private equity firms in their evolution. Oak Tree was a good example of that. The server is a good example of that. Apollo is a good example of that. They were all originally stress, distress investors, or how to stress and distress back.

Trey Lockerbie (00:11:21):
Walk us through a little bit about how corporate debt is actually priced. I know there are all kinds of acronyms out there when it gets into this category. Like LIBOR, L-I-B-O-R, et cetera, walk us through the interest on top of LIBOR, how things are priced and then how they perform over time.

David Sherman (00:11:39):
So, look, I know you have a pretty sophisticated audience that’s very well appealed in financial terms and financial concepts, but I want to take us back to the basics for a second. So if you think about a company, there’s basically two forms of capital that they use to grow and build their business. One is they raise equity money. I don’t care if it’s venture capital money, stock money from an IPO or it’s equity money, you get the economic spoils, you get the economic failures, you’re bottom of the structure, that’s who you participate. And then there’s, they borrow money.

David Sherman (00:12:12):
No different than if you have a house, you borrow money in a mortgage and then you are the lender. You are the equity. And maybe in between, you get a home equity loan. So that would distinguish two different lenders, a mortgage lender, an unsecured home equity lender, and then you’re still the equity. So debt is top of the capital structure. And then within that, there’s different tiers of who’s more senior than the other, and who has first dips on the business for the assets in a distress situation. But in a non distress situation, in a company that grows and flourishes and you don’t need to have first dips, you don’t need to worry as much about ranking, because it’s doing well, you’re just a source of capital.

David Sherman (00:12:55):
So that’s an important part. Within the debt structure, corporate debt, there are all kinds of things. There are private loans that banks do every day to public and private companies. They issue working capital loans, secured by receivables and inventory. As the world evolves, they now syndicate or offer those out to other lenders. They can be offered in structured products like collateralized loan obligations, CLOs, or collateralized debt obligations like CDOs. In CDOs, they not only buy loans, they buy bonds. And then you have, I have a mortgage where I have a first lean on all the equity of your subsidiaries. Then you have, I have a lean on property plant equipment.

David Sherman (00:13:38):
Those are all versions of secure debt in various ways. And you can have a first lean and a second lean where the people with a first by definition, get an interest in the beginning and the people in the second get the residual value of the collateral. And then you have unsecured debt. This is just debt they owe you. There’s nothing backing it. So, and people automatically assume if you have a secure debt, it’s always fine, but that’s not true. Just like a house, as we know from 2008, you could have a secured loan and find out that you lose money because the homeowner owes more money than the value of the house.

David Sherman (00:14:12):
It’s upside down. Happens just like that in corporate America, happens like that in asset backed securities, happens like that in mortgage backed securities, but there’s unsecured loans. Then there is what we call mezzanine financing. This is way down to the bottom capital structure. There’s usually a lot of debts, usually in growth equity stories or private equity, meaning LBOs. And they are looking to get equity-type returns in a lender’s position where they’re [inaudible 00:14:39] and you have preferred stock, which may be perpetual and not have to pay you dividends. So it’s sort of the worst of all worlds. You don’t get any of the economic spoils in your stock. You’re what I call a Stuckey. You’re the new Stuckey. Or you could have a preferred stock that has real teeth.

David Sherman (00:14:55):
You can get board control, have a maturity, and then you have equity. So I think it’s important to think about all of those aspects when you think about the debt structure. And when you analyze a company, I think the easiest thing do is figure out what you think the company is worth as a total company, unlevered. Everything once stood with leverage, whether you’re an equity investor or you’re a lender, what is the company worth outright before we do financial engineering? Now, what are my risks to the downside? What are my risks to the upside? How much of those risks are macro and exogenous that are really out of your control? Cruise lines were thought of as a great business until COVID showed up.

David Sherman (00:15:34):
That’s an exogenous risk, an outside risk people may not have thought about or perceived. And some people may have had the vision, think it’s got pandemic risk. And then there’s the business risk, your competitors, the industry, is it changing? If you were a company and made thermal paper for fax machines, not such a great business today. And then there is the execution risk, can this management team lead it? So going back to my steel example, you can have the brightest, best management team in the world, but you still have a steel company. There’s only so much they can do. By the way, management is important, but in equity, people really look at who the leader of the team is.

David Sherman (00:16:15):
They really say who is running the company? I’m investing and putting a heavy weight on that person. I try to use the word bet because I think there’s a big difference between betting and investing. In bonds, you just want to know you’re going to get your money back. You just want a competent team that’s not going to mess it up. There’s a big difference. So you can now start seeing the distinguishment between how an equity investor might think and a bondholder might think. Those are important points. And that also doesn’t change the fact that equity investors might find hidden assets. Well, they’re also hidden assets for bondholders. If those assets are realized, the rating, the credit rating of a bond may improve.

David Sherman (00:16:52):
So I’ll go over that in a second. If you’re an equity investor, you get the economics of that value. So you get a higher upside, but bonds tend to be rated. And the rating agencies, Moody’s and S&P are the leaders, do a really good job when they’re issued a rating. Triple A, double A, single A, triple B. That’s an order of ranking from bets to worst, that’s all investment grade. Now high yield starts at double B, single B, triple C, and then of course our famous default. If you can find a company that got downgraded from investment grade to high yield and then is going to work their way to become investment grade, and you can make a lot of money because the spread between what you’re being paid and the treasury is wider or bigger or more yield or fatter when it’s lower credit quality. When it’s higher quality it’s narrow.

David Sherman (00:17:41):
So a company that was originally trading 10 year bond, trading at 90 to 120 basis points, that’s 0.9 to 1.2% more than a 10 year treasury, might be investment grade. It got downgraded, all of a sudden it’s trading, it’s a double B, triple B. So it’s flip rate. All of sudden it’s now trading at 225 basis points off the same treasury. That’s 2.25% more cushion, more [inaudible 00:18:08] getting paid more for your risk. Now they continue to deteriorate and they go down to single B, and now they’re yielding 4% or 400 basis points more, 500 basis points more. And by the way, these points change both with interest rates and with business cycles and with market cycles. Right now they’re very tight, interest rates are also very low. But the point is that company that’s a single B, if the management team gets replaced and a new team comes in and they say, we’re committed to becoming investment grade again.

David Sherman (00:18:36):
Well, if you have a 10 year bond, you have what they call a duration. And again, I’m picking things to help give you terms. So duration is a concept that for every 100 basis points or 1% interest rates, so up or down, the price movement will be in the inverse. So interest rates go up 1%, 100 based points and it’s a 10 year bond, the bond will lose eight to 10 bond points. So a zero coupon bond, somebody doesn’t pay cash, always its duration, its maturity. The reason duration shortens when there’s a coupon, but you get paid every month or quarter or semi-annual annually is because it’s a present value calculation.

David Sherman (00:19:13):
You’re getting money today, which affects the value, right? Because you’d rather have money today than in the future. But in that case, in my example, a company issued a 10 year bond, it instantly gets downgraded from single A to single B. It immediately goes from 100 basis points spread over the treasury. Again, this is extreme, but it’s for illustrating purposes, to 500 basis points of trade. That’s a 400 basis point change on a 10 year bond. Well, 10 times four is 40, so you’re going to to lose 30 to 40 points in bond price. Bonds are priced, 100 is par. That’s 100% of principle. 100 means it’s worth 100% of it’s face amount or principle. So you’re going to lose 30%. Now the company’s committed to becoming investment grade. The new guy realizes it’s a good company, he’s going to make the same 40%.

David Sherman (00:20:02):
So ratings and where they are in the pecking order and improving analysis is the one way to make a total return. It’s not the only way. In fact, it’s one part of the way, but I’m trying to explain bond concepts in a very quick format for your investors to think about. And then, of course, a big difference between investment-grade bonds and high yield bonds for instance is investment grade bonds generally are not callable, meaning the company doesn’t have the right to refinance them like you do with your mortgage, maybe six months before maturity, but not sooner. So [inaudible 00:20:32] got a 30 year mortgage, you can refinance it whenever rates go down. But if a company takes out a 30 year bonds investment rate, most investment bonds don’t allow them to refinance it in the near future. In high yield, it works differently.

David Sherman (00:20:47):
In high yield, there’s no such thing as a 30 year high yield bond that wasn’t downgraded, but let’s take a five year high yield bond or a seven year high yield bond. They might not have the ability to refinance it for two years, but then after two years, the ability to refinance at various prices, maybe initially at two or 3% over face 102, 103, and maybe it drops down every year by a point until gets the buy. So just like a mortgage with prepayment speeds that affects your maturity or your average life or your duration, which is called convexity, you have the same issue, much more so in high yield than you do in investment rate. So those are again, other nuances. So as you start going to the bond market, there are things you have to become familiar with.

Trey Lockerbie (00:21:29):
And touching on a couple more nuances, specifically around duration since you touched on it, can you describe the difference between short duration and low duration?

David Sherman (00:21:38):
We have two strategies of which one of them is a short term high yield bond strategy, which by the way, as a product would be misnamed and we should have called it an ultra short term high yield bond product. And what we mean by that when we are talking about our own individual strategies is a short term security. And generally the best world is deemed to something that has a maturity of one year or less, or a duration of one year or less. Can have a longer action maturity because your maturity is to be different than your duration. So we think of short term bonds as anyone who wants to put money to work for six months to a year and a quarter, like that one year segment.

David Sherman (00:22:22):
I mean, it’s not a great asset class to invest in if your kid’s going to college in September and it’s June and you need to make tuition, because you could have prices go out, but you get the prices go down and what you thought was a guaranteed tuition payment, all of a sudden has a loss. You just go put in the money market, put it in a checking account, buy a three month CED. You shouldn’t take price risk with it. If you say, what about next year when they’re a sophomore? Perfect product for that. Because the implication is over a 12 month period of time, you’ll have all your principle back plus a return. What we mean by low duration strategy, and we have a low duration high yield strategy is we mean more than one year, but less than three years.

David Sherman (00:23:08):
So that would cover your junior and senior year of college, and in return for allowing us to take a longer horizon in investing, we should get paid more returns, just like the equity market. Most equity investors, they took a five or 10 year perspective and didn’t look at their portfolio unless they thought they made an egregious mistake, would do better than people that focus on what did the market do in the last three months [inaudible 00:23:33] Not always, but generally that’s the concept. So in our particular par like with our products and our strategies, not everybody has the same exact definition.

David Sherman (00:23:44):
Short term generally means one year less, low duration applies more than a year, less than three years. We actually focus on nine months to about a year and a half in our low duration. So we’re even lower than most low durations, but in the investment world, short term securities almost always refer to things that will be one year or less from a balancing perspective.

Trey Lockerbie (00:24:05):
You have another strategy called the responsible credit fund. And I love that name because it somewhat seems redundant a little bit maybe, as far as we want it to be responsible, because a question comes to mind, what is the alternative of that? But I’m curious, walk us through what is implied with the responsible credit fund.

David Sherman (00:24:21):
In the responsible credit strategy, the implication is that we’re going to be ESG mindful. ESG, meaning environmental, social, and governance mindful. Obviously, the question is why did we pick that? Is it because it’s a current trend? Is it a marketing ploy? Is it greenwashing? I can answer all those questions. The answer is no to that. But the reason we called it responsible is because we want to take a responsible approach to ESG and we want to have mindfulness to embrace the purpose of ESG, but we recognize that today there is no standardization in the equity market and certainly not in the bond market of what is ESG, what is it?

David Sherman (00:25:07):
And how do you measure the impact and how do you distinguish one ESG company from another? So my concern when we were thinking about this was the world is going to come up with an ESG algorithm and ranking system. It’s going to happen and it’s going to happen to the equity market, it’s going to happen in the bond market. And the reason it’s going to happen is the same reason why there are credit ratings in the bond market, because there’s a demand and need for the product, people want clarity, transparency, understanding, and everybody wants a third party to step in between. And there’s so much money to be made. The forces of capitalism will create it to happen.

David Sherman (00:25:46):
So if you’re Moody’s and S&P, you’re working on creating an LST mandate of how you’re going to measure LST and how people can adopt it. In fact, in the leverage loan world, so leverage loans are bank loans issued primarily in private equity LBOs that the banks don’t want to hold in their balance sheet, they want a syndicate mutual funds, pensions, high network individuals, everyone else but their own balance sheet. The LSTA has said, which governs how you trade these things and the rules, they’re working on the ESG ranking system. So the money’s going to be behind it because it’s a business. And we recognize when that happens, unintended consequences can occur. So for instance, in credit ratings, we think the credit ratings do a great job at the initial time of underwriting when they issue it, but they don’t do a great job following you, and they do a terrible job.

David Sherman (00:26:34):
So we believe that there are inefficiencies that you can make money in the corporate bond market based on credit rating, more so in high yield than investment grade, but equally so. And we actually think there’s a whole [inaudible 00:26:44] rated bonds that could be deemed investment grade or high. So it’s going to happen in the ESG world. And the concern we had when we launched the strategy is that the constraints of what is deemed ESG enough may limit your investment opportunities for the sake of ESG, as opposed to being mindful. So that’s why we use the word responsible investing. It’s a mindful approach. And by the way, our system’s internal, we think we do a pretty good job.

David Sherman (00:27:10):
We’re constantly looking to refine it. We welcome third parties to develop the system. We hope that we’ll always be an ESG fund, but if the ESG requirement becomes so great that you’re giving up reasonable returns, we’ll just be ESG mindful. Because they’ve narrowed the universal. I think, I don’t know what other funds are doing. I’ve seen very few investment firms that are using an ESG concept that have negative attribution as well as positive attribution. So what do I mean by that? Well, I mean that let’s take Tesla. Now, almost everybody thinks Tesla is ESG mindful, and they’re great. And they might meet our minimum threshold, they might not. We haven’t actually scored up Tesla, but I can tell you one thing where they’re going to get a negative attribution.

David Sherman (00:27:52):
Look, it’s got an ingenious CO, but he has got some governance issues. He’s got some issues, right? The SEC’s sanction. You can’t say they’re perfect and give them only positive attributes without considering that he has some liability or risk as a CEO. So we’d give the CEO from a governance standpoint, a negative attribution. I mean, Elon Musk is a a genius for sure. We’d also give them a negative attribution because their business was initially based, and we’ll see how it goes in future on government subsidies. That doesn’t make it not a great ESG company. I’m not trying to pick on Tesla. I’m trying to pick something that most people in common world consider immediately it’s absolutely ESG friendly, and where one has to consider the holistic picture.

David Sherman (00:28:40):
The other thing about Tesla, and not picking on is everyone assumes because it’s electric cars, it’s very green. But if you are in Virginia, West Virginia charging up your car with electricity, coal fired, I don’t know what that carbon footprint impact is. So there’s a lot of issues with ESG, which is why we called it responsible. Our system does have negative merits. In fact, one of the positions… We disclose our positions every month. So one of the positions in our portfolio is something called copper mountain, which according to copper mountain, the Canadian government has named it the most ESG friendly copper mining company.

David Sherman (00:29:14):
But when we did our underwriting, we decided it qualified in the portfolio in a 20% basket. So we say 80% to meet a threshold and 20% has to be some ESG attribute, but isn’t meeting our threshold. So it’s in our 20% cut out, but it doesn’t actually make it into our 80% completion. So that’s how we’re approaching responsible investing, that’s how we’re approaching ESG. As I mentioned, I had the privilege of mentoring under Joe Steinberg. When I mentioned to Joe that we were doing a responsible credit fund, he said he wanted the irresponsible fund. Because such pays.

Trey Lockerbie (00:29:48):
Well, there’s one holding in that strategy, I think that stood out to me, and that was micro strategy. Because depending on who you ask, and I swear I could go to both sides of the aisle on this one company, and I should also preface, I don’t know if the debt you’re holding is similar to the debt they used by Bitcoin, but obviously that’s a hot topic for discussion around, especially with ESG involvement.

Trey Lockerbie (00:30:10):
It could either be the most ESG thing you could do, it’s far on the environmental side, depending on who you ask, or the worst thing possible, depending on who you ask. So I’m just curious, that one stood out to me, maybe walk us through that holding in particular and maybe just how you approached it in general.

David Sherman (00:30:26):
Okay. So first of all, we own the micro strategy paper in multiple of our strategies and products. It’s a good question. So let me go back to our responsible investing strategy. There is no information that is readily available from micro strategy on an ESG policy. I’m sure they have one. We haven’t really been very successful in getting one that is satisfactory for us to deem it on a scoring factor system, to qualify as ESG in our 80% bucket. Remember in our responsible credit fund, we have an 80% bucket, it has to be, we have a 20% percent sort of, they’re not exclusionary, but it doesn’t meet our bucket. So the distinction that 20% is it’s not going to be coal.

David Sherman (00:31:08):
It’s not going to be guns. It’s not going to be people that take advantage of children overseas. It’s going to have your traditional, this is exclusionary, we never buy. So this is things where you can argue there is some ESG benefit, but that it doesn’t meet our threshold. So it’s in the 20% bucket. That bucket is about 14% today of total names, I gave you two of them. But it’s not just about environmental. You mentioned green. It’s also about community commitment, social commitment, customers, suppliers. I mean, you can make it without being green. I mean, I’m not sure some companies are green focused. They maybe are governance focused or social.

David Sherman (00:31:47):
I’m not sure it needs the best governance either by the way, but it certainly provides a controversial, but social attribute, which is the democratization and decentralization of store value something. I mean, I’m avoiding the word currency because to me, currency is something where you’re required to accept it by legal tenure by the government. So you’re not required to accept it. We didn’t buy it for the Bitcoin. In fact, it’s the thing we like the least about the company. The company has a very good software business. They issued this debt that is secured by that business. There are debt-incurrance tests, prevent them from layering more and more debt on top of us.

David Sherman (00:32:27):
It was originally a smaller issue off the run and it became so much in demand, they upsized it pretty dramatically. And they cut the pricing by the way. That’s what they do in this environment because today capital’s commodity, that hopefully will change in the future, but we felt you were getting an outstrict return for a money-good credit meeting. We thought the underlying business supported the debt with more cushion underneath than the debt. So there was plenty of residual value. And then what made it interesting was that the proceeds were used by Bitcoin and that Bitcoin is pledged to this debt.

David Sherman (00:33:01):
So Bitcoin’s worth zero, the core business covers the debt and if Bitcoin’s worth whatever, it’s like a loan to value. We have that collateral that improves our credit profile, which also by the way, Bitcoin stays where it goes, it goes higher, they are likely to eventually refinance.

Trey Lockerbie (00:33:18):
Last question on that was just around the minimum qualification to even purchase an asset like that. I mean, I imagine that’s why people find someone like Cross Bridge, and you’re sponsored, well accredited people to go out there and buy this kind of product. But I’m just curious on the backend side of things. If micro strategy, let’s say, for example, goes to market with this debt product, where is that listed? What exchange is that on? How do you guys even go about the planning of just purchasing then?

David Sherman (00:33:45):
It would be great if debt was traded on an exchange like stocks. Sometimes, generally not. And also it’s very, if you are an investor, can’t buy in at least 100,000 [inaudible 00:33:58] lots, but ideally million, you get what we call retail ripoff. Meaning the broker-dealers charge you a big spread to transact. So hopefully as technology advances and the world becomes more focused on using our technology to create less friction to buy and sell things in corporate debt or mortgages or asset backs, that will resolve itself. But for now, probably the most efficient way from a transaction cost would be for either people to own ETFs that are passive or to own and actively manage funds.

David Sherman (00:34:34):
But the way it trades is quite frankly, the way the stock market used to trade before there was technology. There’s a market maker and there’s a bid ask spread and they make their money by taking risk or better yet, matching up buyers and sellers. So it’s that kind of market. When I started in the business, the phone was how you transacted. Then it became the phone, you transacted but you got information via faxes. Then you got information being computer systems such as Bloomberg. That is the system where brokers put in electronic markets that they are quoting or making. A lot of times it’s quoting because they don’t really want to take risk. Meaning, well we’re guessing it’s here, give us an order and we’ll go out and find out for you.

David Sherman (00:35:15):
There are some exchange traded when we sometimes take a big chunk of a new issue called anchoring, we offer and try to request it being listed on an exchange because it’s a mutual fund, we think the more transparency and the more opportunity for people to participate, the greater the markets. There’s this concept that started in the leverage loan market. And then the private place market was even before that. So when they call deals, they get two or three guys in a room, they chop up the debt, they keep it and guess what? It never trades. So there’s no price volatility. We don’t think that is best business practices. We’d rather see it owned by a lot of people and if it goes up, we sell it. If it goes down, we could buy more.

David Sherman (00:35:52):
If we want liquidity, we get liquidity. If we made a mistake, there’s a market. So when you look at private funds, you have to consider the club nature of pricing. So again, and the worse the credit quality perceived, the more bid asks spread and less transparency there is in pricing. So that’s the other reason why high yield was interesting, was you learn very quickly if you’re trading government bonds and you’re on the broker dealer side, you’re trading for a 64th, maybe a 32nd kilo. You’re trading investment grade bonds, you’re trading for 64th [inaudible 00:36:26] When I started in the business in high yield back the ’80s, you could trade for unconscionable, but you could trade for four or five points. Very typical high yield trades for quarter, sometimes they ask for [inaudible 00:36:36]

David Sherman (00:36:37):
Obviously the lower maturity, shorter duration is tighter. Obviously if it’s in the ETF, it might be tighter, but it’s a widespread business in a period where you can buy stocks of Robinhood trials for free, but it’s a hard individual market to participate.

Trey Lockerbie (00:36:54):
One thing that does trade on exchanges pretty easily are SPACs. And I want to talk about them because you’ve been investing in SPACs since the mid 2000. So you have a lot of experience in this area. It’s not just a hot sector to get into, like for a lot of people. So I’m curious what has driven you now to launch a SPAC ETF?

David Sherman (00:37:14):
So there are various product cycles and various opportunities within the SPAC product cycle to invest. I’m going to specifically address your question on why we decided to launch SPAC ETF, and specifically the segment of that product cycle we’re looking at. And then you can explore other areas if you want to know. So again, I know you have a very sophisticated audience, but just to get everybody who may not be quite sophisticated on a level playing field, simplistically, a SPAC is a company that goes public or an IPO process where people give the proceeds or the money to the SPAC, except there’s no business. There’s nothing.

David Sherman (00:37:50):
They’re selling you a dream or an opportunity for a future business opportunity for your cash. And [inaudible 00:37:57] they may be focused on a specific segment or industry, but that’s what it’s. So you, the IPO investor, give them the cash and you get SPAC shares. It may be units which consist of shares and warrants. It may just be shares. It may split. There’s lots of pieces. It’s an arbitragers dream of the different pieces, but you’re going to get ultimately shares. So if you get units and you sell off the warrants, you’re getting shares, you sell off the shares, you’re getting warrants. Why is this important? Because what happens to your cash? It gets put in a trust account, held where holds pretty much T bills. And that trust account is for the benefit of the shareholders.

David Sherman (00:38:35):
So when public cash that you gave them to go public goes into a trust account with T bills for your benefits, and now the people that launch the SPACs, the sponsors are looking for a deal. You’re hoping they find the next urgent galactic or draftings, or something a little bit more arithmetic in cash flow like a Jupyter acquisition, or when fully bought Triple C, which was a public company that then became a high yield credit private equity that’s now becoming public and they’re using the [inaudible 00:39:05] And you as the investor might be thinking about who is my sponsor? Is it a private equity shop, a hedge fund, industry players, people that have big jobs in investment banks?

David Sherman (00:39:18):
You make an investment on management, are they going to find a good deal at a good price in a quick period of time? Because a SPAC has a life, typically of two years or less. And because you’re getting bells and whistles with your stock getting warrants or rights or even founder shares, by the way, you want a good deal, you get a levered or returner better gearing. Now, why does a sponsor [inaudible 00:39:41] Let’s back up. That’s what the investor in the IPO gets. There’s various cycles. Why does sponsors? Sponsor does this because on a $200 million SPAC, there’s lawyer fees, there’s investment banking fees, there’s registration SEC fees.

David Sherman (00:39:54):
There’s putting a team together to go look at the industry and find acquisitions. That costs let’s say in a $200 million deal, $8 million. So they’re going to put up to $8 million of risk money, meaning they don’t get any of the money that’s sitting in collateral trust. That’s the money to get this thing launched, operating, to find a target. And if they don’t find a target successfully, they lose all their money. Whereas you the SPAC investor, if they don’t find a target successfully, it goes to liquidation. Remember those that cash is sitting in a trust account and T-bills for your benefit, you get those proceeds. So you are for simplicity purposes, principle protected.

David Sherman (00:40:28):
So a SPAC issues $200 million and they put $200 million in the trust account and it’s earning interest, don’t forget. That’s for your or benefit. And sometimes SPACs put in $210 million against $200 million per share. So there’s over collateralization. But the sponsor gets no benefit, they only get a benefit if a deal is consummate. A merger, a business combination. But how do they get rewarded? They effectively get 20% or more of the upside. So like a hedge fund. It’s a pretty nice deal, right? Put up eight million bucks they get a deal closed, the value of the stock stays at $10 or parody, same price you issued it at, 200 million. They just got $40 million.

David Sherman (00:41:07):
Eight million to make 40, the trades down in half and only goes to $5 a share. You could have lost a lot of money if you stayed in the deal, they still make money. So there’s a misalignment to some degree because the fees are so egregious for the sponsors, but there’s also an alignment that if they get a good deal, you do get to participate. Now that’s a basic spec. There’s one other point I need to mention. When they announce a transaction, you the shareholder, not the wire holder, not the bells and whistles, you as the shareholder can vote for against the deal. You vote against the deal, they can get to keep looking to liquidation. And a liquidation, the only people that get the benefit of the trust are the stockholders, not the wire holders, not anybody like that.

David Sherman (00:41:45):
If you vote for the deal and the deal goes forward, even the shareholder don’t have to agree to be part of the merged company. You can say I’m voting for the deal because I want my money back. You have the right to redeem with the benefit of the trust account. Only your probation, not excess. So if it’s 200 million trust and 50% of the people agree to go forward and take the deal. And like in the deal that just closed recently was Rocket Labs, I think they had 90% or more agreed to roll into Rocket Labs, which is a spaceship launching company, but the other 10% or less than 10% percent said, “I want my cash back.” And they got their cash back. Now, part of the reason for the cash is the target’s [inaudible 00:42:26] cash, whatever, we can spend time on that.

David Sherman (00:42:27):
But we launch the fund because historically, if you ignore the period from, let’s say labor day of last year, meaning labor day of 2020, to let’s say St. Patrick’s day of 2021, other than that brief period of time, most of the time in order to induce you to give them the cash while they look for deal, you have to get paid something on your money [inaudible 00:42:51] However they did it, they had to induce. Whether it was with warrants or over collateralizing the trust that you could then redeem for the over collateralized amounts, they had to induce. And most people that buy SPACs as an IPO are in the secondary market are looking more as arbitragers, getting a return on my money, and then if you announce a good deal, I get to participate.

David Sherman (00:43:13):
So think of the SPAC shareholder or unitholder as a convertible bond with a two year maturity with no coupon where you’re buying it either at 100 par or you’re buying it at a discount backed by T bills. And if they announce a good deal, you get equity upside. And if they don’t a good announce a good deal, you make a return in a yield. Now in a world today where the convertible bond market, half the issues have a zero-coupon and are trading at a 35 to 50% premium over the current stock price, it’s kind of an attractive asset class. And we looked at, and we bought SPACs in the past where we look at it either as exactly like that, as a convertible bond opportunity.

David Sherman (00:43:56):
So in the ETF, we’re not quite that focused. In the ETF we are saying is we’re going to buy at the IPO or the secondary market, units and shares at collateral value or discount collateral. Effectively, we’re not taking principle risk. And if they liquidate, we’ll get our money back. If they go up, we can sell them. If they go down, we can buy more. If they announce the deal, it’s a great deal and it goes up above redemption value, collateral value, we can sell. If it doesn’t go above the redemption value, we’ll redeem. So today, to give you an idea, I just want to look at a piece of paper.

David Sherman (00:44:33):
So we just ran it today. Again, this is going to change, this is going to be announced a little bit in the future. But to give you an idea, this has become a huge market and it’s become 10 to 15% of our assets across the board, just in this kind of product. It’s a cash alternative product. You’ve got two year maturity or less. You’re buying at a discount for almost like commercial paper, a discount. So to give you an idea, today, there are total amount of SPACs, approximately of 550. 550 SPACs. And the total amount of cash in trust, it is over $170 billion.

David Sherman (00:45:09):
Now, if all of them find deals, [inaudible 00:45:11] deal size is about $2 billion, you’re going to have 550 new companies entering the smaller midcap market with an enterprise value that exceeds $200 billion, because the owners typically own a minority interest in the combined entity. That’s a pretty big market. And of that 550 SPACs, about 140 have announced deals and the rest are looking for deals. And what’s interesting is that SPAC market today, if you bought the ones that are looking for deals, announcing deals and you ran them to their liquidation date, the median is almost two and a half percent yields deals.

David Sherman (00:45:50):
That means there’s a whole bunch yielding more, obviously a whole bunch of yielding plus, some of the reasons some are yielding less because they’re a more preferred sponsor like [inaudible 00:46:00] or because they have a deal in hand, right? So if you have a deal and you think it’s going to go through, it’s going to close in 90 to 150 days. So the liquidation date’s longer than that. So that’s one way of investing and SPAC that has announced the [inaudible 00:46:13] and then if the deal goes through, you’re going to redeem. That’s great. You make very good short-term returns. Obviously if the arbitrage risk deal doesn’t go through, you now extend to the liquidation date.

David Sherman (00:46:25):
By the same token, you also have stuff that hasn’t announced the deal yet, that if they announce the deal, your maturity’s coming up sooner if they close, which is going to improve your yield. So we think the asset size is big enough and we think that if you’re disciplined, you can provide people very, very low duration yields in that timeframe. And let me be clear, if you read our perspectives, we specifically say we’re only buying things, stocks units at or below collateral value prospect. So we’re not paying a premium. So if the world becomes like February, they may not have so much to buy at the moment. I don’t think that’s sustainable.

David Sherman (00:47:02):
And if we also announce that we will dispose of the shares or units, within 10 business days post a successful combination merger. I mean, quite frankly, I don’t ever expect or highly unlikely to expect to go beyond the redemption. We’ll either sell it or redeem. Why is it 10 days? Well, I hope you never make a mistake. Sometimes you do. It gives me a little bit of room not to violate rules for the investor. But our intent is not to roll into the new deal. That’s a different decision. That’s [inaudible 00:47:33] I like the deal, what’s the company’s opportunities. That’s a small cap, midcap decision. And there’s huge opportunities, just not what this one’s going to do.

Trey Lockerbie (00:47:41):
Well, you’re making a lot of sense, David. It was just occurring to me while you were speaking that there are a lot of similarities with the strategy to something like a venture capital firm. I mean, it seems like if we go back to even one of the earliest points you touched on with the high yield corporate debt portfolio, you’re talking about a theme of expected losses. You’re expecting some of these things to go to zero.

Trey Lockerbie (00:48:01):
And if you bundle them up into a portfolio of sorts, you really only need a few outliers to do very well or the portfolio itself to do well in aggregate, right? So I’m thinking if I’m understanding this correctly, you’re packaging together a lot of different SPACs, some of which might just not find a company and get liquidated. Others might find a unicorn and you just need a small percentage of that package to outperform to get an overall aggregate good return.

David Sherman (00:48:28):
Our number one mantra here at our firm is to protect principle first. And the way to make money is not to lose first. That’s what we’re good at. Other people are great at making money and taking principle risk, and figuring that out. We try not to lose money. We do lose money. We try not to, but our mantra is don’t lose money, focus on principle. The Warren Buffet return of principle is the fundamental basis of investing. If you get a unit, a SPAC is typically issued in unit. Typically issue is a stock and a warrant. Eventually, the stock and the warrant split into two separate trading deals.

David Sherman (00:49:03):
So what we’re suggesting is we would actually sell the warrant, take that cash, reduce our cost basis in the purchase price of the stock, right? Because we know if we paid $10 for the stock and there’s 10 or more in trust, we’re going to get 10 or more liquidation or merger. And if we sell off the warrant, which is all the future upside, we’re going to guarantee our return, our lock in our return, I guess is a better way of saying it, at three or 4%. And if it’s a good deal, it’s going to trade up anyway, and we’re just going to make less. In the warrants, you are correct. There’s a whole group of SPAC investors and here value investors may take interest in this.

David Sherman (00:49:35):
They actually look and say, if I buy the IPO and I sell off the stock and I keep the warrant, I’m creating cheap, long term poll options of about five years, right? And if I have a portfolio of them, yes, if they liquidate the word zero, if the deal’s no good in trades below 1150, they’re worth zero. But I only need a couple to do really well, and I make a return on like every venture capital where having a portfolio of a lot of them is likely to give you the outcome you want. I do want to warn people two things about the warrants which are very important. If a SPAC announces a deal within the first 12 months of going public, the warrants are European style, meaning you can’t exercise those warrants until that 12 month period is gone. So they don’t price like a normal call option that you and I would be familiar with.

David Sherman (00:50:24):
And actually, you get a lot times, you can wait to see the dealers and pick up the back half yes, the warrant’s likely to double, before you figure that out, you lost the first 100% move, but you can evaluate the situation and that may be a better way of doing it, may not, that’s your strategy. The other thing is a lot of warrants. The company has the right to force you to redeem or convert when it goes up. 1850 doesn’t mean you’re not purchasing the upside, but again, it creates another technical trading aspect to it. I think it’s perfectly fine to own a portfolio of warrants.

David Sherman (00:50:53):
I’m not a venture capital investor, I don’t invest in things where if you win the litigation, you make a lot of money, if you lose it, you’re wiped out. It’s just not what our discipline is, but it’s certainly a legitimate strategy. So I want to clarify what you’re suggesting. I’m not suggesting anything other than it’s a very perfectly fine investment strategy for people that want to do that and they understand the risks. For us, it’s not what we do and what we offer.

Trey Lockerbie (00:51:17):
I appreciate that distinction. If I’m oversimplifying further, the whole idea of SPACs, as you just described to me, sounds a lot like going out and finding a great jockey who’s then going to go find a great horse. It’s just a really oversimplification. And you mentioned 550 SPACs out there, meaning 550 sponsors. So that sounds like a lot of due diligence, as far as going out there and saying, who is the sponsor we want to back. So walk us through a little bit, how you approach evaluating and how many of them are going to make up the ETF.

David Sherman (00:51:50):
So, first of all, 550 SPACs will not necessarily mean 550 sponsors, because many sponsors have SPAC one, two, three, four, five, six. So that lowers your number of sponsors. But that doesn’t change the question. So I’d like to tell you that doing really good due diligence of the sponsor’s going to give you a significantly better outcome. And unfortunately, I don’t think that’s been the experience. There are a couple sponsors that are definitely more successfully [inaudible 00:52:18] Betsy Cohen, Madrick, although he just had a SPAC that didn’t work out. But you can sort of determine that, but there has been sponsors we had high hopes for based on their history and their experience, and the deal was just, okay.

David Sherman (00:52:32):
There’s been people that most people haven’t heard of and the deal’s been phenomenal. So I’d like to tell you, and the way you do the due diligence is there’s something called testing the waters, and capital markets groups call up large institutions that can write big checks such as ourselves and says, “Hey, would you like a testing the water call or you need management? You get to talk to them. They can’t really tell you any of their targets, but it’s more, let me tell you all about how terrific I am and why this space makes sense. But also is some of it’s sector selection. And that’s actually a bigger point. There’s over 50 SPACs focused on FinTech. I don’t think there’s 50 FinTech good deals at a reasonable price.

David Sherman (00:53:08):
I could be wrong, but I don’t think so. So sector plays a role as well. I actually think sector’s a bigger situation, but at the end of the day, both sector and sponsor, if you’re doing it the way our ETF that we’re proposing is doing it, it’s a random walk. So in fact, it’s such a random walk that someone could buy our ETF for another ETF that’s doing it themselves, that’s competing with us when ours launch or quite frankly, you can do it yourself and you can trade for free at Schwab and Robinhood. So you don’t have to pay our management fee and our expense ratios for running the fund. And in fact, if you’re interested, there’s a lot of companies that provide databases of all the SPACs outstanding and what their terms are, where they trade.

David Sherman (00:53:47):
But a lot of them, or at least all the ones I’ve realized, make you pay for the information. Now here’s the situation. It’s all public information. It’s all filed with the SEC, but it’s so much information and it’s a work so that what you’re really paying for someone to aggregate the information for you in a way that you, as an individual can work And quite frankly, I think, and our hope is in the middle of September, we’re going to be able to give you a basic database for free. If you go to spacobserver.com in the middle of September, S-P-A-C observer.com, all one word, and you put in your email, we’re going to provide you the database for free.

David Sherman (00:54:22):
It’ll be basic, but it’ll give you how much is in trust. What the last price was, what that gross spread is, what your yield to liquidation is. Does it currently have a deal? And if so, what is that deal? Does it not have a deal and who are the sponsors and what’s the [inaudible 00:54:35] What are the symbols? Now, that’s pretty basic information. But if you have that information, you can replicate exactly what our ETF is going to do and what our competitive ETF is going to do. In the pre-merger facts, were really focused on buying things at, of below collateral value, and then either letting them to go to liquidation or redeeming them out as a yield product.

David Sherman (00:54:53):
So as much as I like people to buy our product or other ETFs, you’ll automatically have a better performance. Most likely, if you just do a diversified portfolio yourself. And by the way, it sounds counterintuitive that we would focus on trying to provide that information for free. But again, I believe investor’s entitled to transparency and they have to make a decision. Do they want to do it themselves or do they want to pay somebody? Are our results going to be better? Hopefully, but who knows? It’ll be an interesting test.

Trey Lockerbie (00:55:20):
You mentioned the expense ratio. Now, I’m curious, what does the expense ratio look like for the ETF? And is it net of all the underlying assets in it?

David Sherman (00:55:29):
So the expense ratio is the audit, the tax preparation, the striking of the price NAV every night, the work involved in creating the portfolio, doing the accounting portfolio custodian and custodian has cost. And of course not insignificant is our manager, because I want to get paid for the work I’m doing. So in our SPAC ETF, I don’t think we put in the registration statement, but we’re going to propose an 80 basis points expense cap, which means the investor will pay 80 basis points off the top to both pay us and all those other expenses were not always base points.

David Sherman (00:56:04):
And if the SPACs assets, AUN, grows, the ETF assets grow, that expense rate shall come down because custodian’s relatively variable, but administrative costs, board of director costs, all that stuff’s fixed. So you’re going to bring down your costs. Ultimately, if interest rates remain low and the returns that we produce under the strategy aren’t two and half to 8%, but they’re one to 3% net. And obviously, maybe we have to reduce our fee to help improve the expense cap, we’ve done that before.

David Sherman (00:56:37):
And some of our other mutual funds we’ve actually reduced the expense cap and earn less in order to make the product more reasonable for the work we’re doing for the underlying investor. It’s not something very frankly, I’m that interested in doing, but if it’s necessary I will.

Trey Lockerbie (00:56:51):
And how many SPACs do you expect to make up the ETF? Is it typically around like 40 holdings or so? But is it going to exceed that?

David Sherman (00:56:59):
It depends on the market. If there are 500 SPACs and what’s the liquidity, what’s the size and what are the yields? To own a SPAC at a mediocre yield doesn’t make sense. I mean, today we have over 150 SPACs in the assets from match. So I mean, when we start the ETF, probably not because it’s going to start with very little assets, but as the assets grow, by definition you’ll grow your SPAC number. The other issue is owning more than 9.9% of a SPAC has issues regarding 13 Ds, 13 Gs. Owning 19.9% has serious issues because it involves ownership, control issues. So if the SPAC assets grow, that obviously by definition make you want to expand. And also there’s a liquidity aspect.

David Sherman (00:57:42):
I mean, if it’s a $200 million SPAC, you can own five million, but you can’t own 40 [inaudible 00:57:48] So those are the issues. So quite frankly, the SPAC market’s big enough today. But one of the issues we actually have thought about all of our strategies are capacity strained. And I believe every strategy out there, whether it’s equities or whatever, has a capacity limit, both on the manager and the actual asset cost. One of the things we explored when we launched ETF is based on today’s market, and if the market deteriorates to a more normal market like what it was a year or two ago, how big can our SPAC grow?

David Sherman (00:58:15):
And is there a way that we could capacity [inaudible 00:58:17] We’ve come up with a solution for that [inaudible 00:58:19] So we’re going to be very mindful using the same words as the [inaudible 00:58:24] of not growing assets for the sake of wrong revenue.

Trey Lockerbie (00:58:29):
Fantastic. Well, David, this is very compelling. I mean, it’s a whole new perspective on this asset class for probably a lot of our listeners, but myself included. I feel like I could talk to you all day, but I want to be mindful of your time. I have a lot more questions, but I think this is a great place to wrap. Before I let you go, definitely provide our audience the resources available to them and where they can learn more about CrossingBridge and yourself.

David Sherman (00:58:53):
For those who are interested in learning more about CrossingBridge, the best place to go is our website, www.crossingbridge.com, C-R-O-S-S-I-N-G B-R-I-D-G-E .com, CrossingBridge all one word. You can also, if you want, email me directly at Dshermans, S-H-E-R-M-A-N @crossingbridge.com.

Trey Lockerbie (00:59:14):
I would love to have you back on the show. This was just such a pleasure and a really fun conversation. And so thank you so much for your time. I really appreciate it.

David Sherman (00:59:21):
Well, thanks for the opportunity.

Trey Lockerbie (00:59:23):
All right, folks, that’s all we had for you this week. If you’re loving the episodes, please go ahead and follow us on your favorite podcast app and leave us a review. Or you can always reach me on Twitter @TreyLockerbie and don’t forget to check out the resources we have for you at theinvestorspodcast.com. We’ll see you again. Next time.

Outro (00:59:39):
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