# Aswath Damodaran (NYU) | Private Credit Is the Biggest Loser When AI Corrects | #15 **Channel:** Fixed + Floating - The Credit Podcast **Source:** https://www.youtube.com/watch?v=6gbls3i6Aww **Transcript page:** https://www.withtranscript.ai/video/6gbls3i6Aww ## Chapters - 0:00 — Introduction and AI Market Overconfidence - 7:38 — Valuation Fundamentals: Pricing vs True Value - 16:14 — Depreciation Critique and Financing Interplay - 27:21 — Overcapacity and Book Value Misconceptions - 31:46 — Lifecycle Financing and Convertible Debt Solutions - 39:18 — Default Risk and Optimal Capital Structures - 50:42 — Mindset Differences and Valuation Best Practices ## Transcript **[0:00] Speaker A:** Who are these lunatics who are lending money to the data centers? I think private credit is vastly overrated for intelligence. People assume these private credit guys must be smart guys. No, they're not. They're sheep. You have a company that is losing $2.5 billion right now. Who in their right mind should be lending to that company? The equity narrative is setting what you charge the company. You can make interest payments with potential and promise. You got to make it with cash flows. **[0:35] Speaker B:** Today's guest needs no introduction. I'm very pleased to welcome Asvat de Moderen, professor at NYU Stern, who is focusing on corporate finance and valuation. Today we are going to talk about the intersection of credit and equity investing. Welcome, Asvat. **[0:53] Speaker A:** Thank you for having me. **[0:56] Speaker B:** You've spent the last week arguing SpaceX 26 trillion AI opportunity. You have done some research where you called these themes a big market delusion. So each AI company on its own can be priced on an internally consistent story. But yet, if you sum up all the revenues and all the valuations of all these stories combined, that can't be the case. How do you make that argument precise? And how should an investor work out whether they own one of the more consistent stories or one of the impossible ones? **[1:38] Speaker A:** I mean, it comes from human nature and from the fact that if you have a founder, entrepreneur, somebody who starts a business, almost by definition, that person is overconfident. It's a given. Overconfidence is one of those behavioral traits that has led to all kinds of investing issues. In this case, here's what happens. You have an overconfident entrepreneur looking at a big market. The big market is still unfounded. What's the definition of overconfident? Do you think you can win? You think you will be the one who wins? **[2:12] Speaker A:** You go out and seek venture capitalists. So people who provide you capital are also overconfident people. They think they can pick winners. So it all starts with the behavioral component human beings have, which is they think they can conquer things more easily than you really can. So let's take any big market. It could have been PCs in the 1980s, the Internet in the 1990s, social media 30 years ago, or even China as a big market. This phenomenon plays out hundreds of little pods each. A business starts off saying, I can conquer that market. **[2:50] Speaker A:** And since they talk to other people who buy into their vision, each pod overvalues itself, overestimates its chance of success. So if you go into each of these pods and ask them, are you being rational? Is this sensible? The Answer, you're going to, of course, look at our numbers. We think we can win. But if you do that on every single pod and add them all up, by definition, the sum of what they expect to happen is far greater than what the actual market is. That is at the heart of the big market delusion. **[3:22] Speaker A:** The problem though is if the market's not there, eventually there's a cleaning up to do, which is the actual market shows up maybe two, four, five, six years later. And then some of these companies have to drop off the map because they can't succeed. But a few will make it. And that's the essence of the big market delusion. It's not that all companies are overvalued, but collectively there's an overvaluation. **[3:47] Speaker A:** So that's a business phenomenon. The question you asked is how can investors pick a winner? Hey, that's tough to do. I mean, first you got to recognize this is a low odds game. If you say, look, I want an 80% chance of success, don't even look here. **[4:01] Speaker A:** The nature of investing in this space is for every five companies you try to do this on, if you're right on one out of the five, one out of the five, your portfolio will be fine because that winner will carry the other four along. It's a different mindset that you got to bring in. It's what a venture capitalist mindset is, right? Venture capitalists don't expect to win an 8 out of 10. They expect to win on 2 out of 10. But the two have to be such big winners, they cover the other eight losses. So as investors, don't be afraid to be wrong, make your best assessment. You have the advantage of looking across these different pods, asking which of these pods is composed of people who are least overconfident. Because one of the things you're wary about is people are arrogant and overconfident, overreaching. **[4:52] Speaker A:** So you want to try to avoid those businesses that are run by people who are so overconfident that they don't take the precautionary steps you need to take to protect yourself if you're wrong. **[5:04] Speaker A:** Kind of reverse. And I think that's all you can do as an investor. Pick the right business filled with people who are willing to admit they're wrong and then accept the fact that you're going to be wrong a big percentage of the time. **[5:15] Speaker B:** In a normal value chain, let's say an automobile, the final product is sold once and the margin accrues unevenly to whatever layer is usually scarce. If you're looking at the AI stack, it's probably the same, right? You have only one subscription price, which has to be split across the model, the data center, the power and the chips. **[5:42] Speaker A:** The AI model is not built on subscriptions. In fact, you're moving away from it. The problem with the subscription model in AI is the product and service itself is expensive to provide. I mean, I was looking at estimates of the Claude Fable that got pulled off the market last Friday because the US government pulled it off or forced Anthropic to pull it off. **[6:05] Speaker A:** It's estimated It'll cost you $6,000 an hour. Drawn fable, $6,000 an hour. And part of the reason for that is AI, especially as you get to these higher and higher levels of products, is incredibly expensive to produce. The data centers, the power, paying for the data itself. Anthropic initially was able to use data that's in the public domain. **[6:28] Speaker A:** So it's an expensive product to provide. And you're right. The value chain right now is, to be quite honest, nobody's making money because the business is still evolving. That's the thing to remember is in young businesses, you're still figuring out who's going to make the money. You're right, though. Eventually there will be parts of the value chain that claim more of the value. And already you can see this battle starting to play out in AI. If you know whether you got a chance, read Satya Nadella's long letter that he that came out on Twitter, which, you know strange because it's a long letter, but you can read the letter about where he thinks AI is going. And you can already see the kind of maneuvering that's happening between the big tech companies and the LLM. Hey, who's going to be the winner in this space? **[7:19] Speaker A:** And you have all these satellite companies circling around trying to get value. So it's going to be a pretty chaotic two or three years, perhaps even longer. Even if AI's promise comes due as to who exactly is going to make money in this space. **[7:32] Speaker B:** That's very sensible if you focus more on valuation. **[7:38] Speaker B:** And I think the model companies, those are much more valued on TAM basis or revenue and then a multiple attached to it. **[7:49] Speaker A:** I'm sorry, when you attach a multiple, you're not valuing your price. They're priced because people don't want to value businesses. They don't. I mean, let's step back. We talk about valuation. **[7:58] Speaker A:** Valuation is basically understanding a business, understanding business economics, making your best judgment on how business economics will evolve over time. When you have young businesses like SpaceX, like OpenAI, like Anthropic. Let's be quite clear. There's a lot of uncertainty about the business, economics about the business. So you know what the reaction of most people, including most VCs, investing in these businesses is? **[8:24] Speaker A:** They give up. They don't even try. See, how do they attach a number? They attach a number the same way you and I attach a number to a house or an apartment. They look at what other people are paying for similar things and they price them. **[8:38] Speaker A:** The minute you tell me you're pricing something, you're essentially giving up on business economics. He's saying, I don't want to confront how the business will evolve and confront the uncertainty. So I'm going to look at what other people are paying. I'll wager that when Anthropic and OpenAI go public, the pricing of those companies is going to be triggered by the SpaceX pricing. That's why Sam Altman and Daria Amadai were sitting at home looking at the SpaceX pricing and hoping it went well, because it's good news for them if it goes well, because that pricing is going to spill over. **[9:13] Speaker A:** The essence of young business is most people don't even try to value these businesses, which I'm okay with, because that's what traders do, right? You buy at low price, you sell at a high price. But if you truly want to confront the valuation of these companies, you have to think about big questions, starting with what exactly is AI going to do? Is it going to provide tools to workers or replace workers? You know why that matters a huge amount. **[9:40] Speaker A:** Your total addressable market year, which is what the business economic spill from, will depend on that first question and how it's answered. If AI is a tool, the market for AI is far, far, far smaller than if AI replaces people. I mean collectively global companies, all publicly traded companies around the world, every single one of them put together last year at $142 trillion in revenues, they had about 20 to 25 trillion in employee expenses. The reason I called the 26 trillion that you see in the SpaceX IPO fiction is even if you took this end game where every sing that's dystopian, every single employee gets replaced by an AI agent. You're looking at a ceiling of at the most 25 trillion. You're replacing them because they're cheaper. It's got to be an even lower ceiling. So there is no way around dealing with the big questions in AI if you truly want to value these businesses, if your Reaction is it's too uncertain. **[10:49] Speaker A:** I don't want to deal with it. That's perfectly okay. **[10:52] Speaker A:** But then accept the position that you will be putting a number on these companies based on what other people are paying, and they're just as much in the dark as you are. Nobody's asking the big, serious questions, at least in the valuation front. **[11:07] Speaker B:** You've mentioned the word young companies, which applies to the model companies. Whereas if you look at the chip companies, those are very mature companies, right? And I think in your book, the Dark Age of Valuation, you have been very pronounced that it is not very easy to value relatively volatile companies, especially if they have such a earnings boost for a relatively short amount of time. **[11:43] Speaker B:** So I'm wondering, how can people think about if they're looking at chips companies and what valuation traps could they find themselves in? **[11:54] Speaker A:** I mean, not all chip companies are mature, right? I mean, clearly Nvidia and ASML are, but there are a lot of young chip companies, arm, for instance, that have come out of the lot. So it's not a question of chip companies being mature, but many of the initial chip companies in this space were companies that have been around 25 years. Nvidia was already an established company. **[12:19] Speaker A:** But there are young chip companies, and in general, this space will attract a lot of young companies which have no business model and no history. It's true. It's not that they're difficult to value, it's that people are uncomfortable with uncertainty. That's a reality. It's a human reaction. **[12:40] Speaker A:** The mechanics of valuing a young company, the mechanics of valuing an old company are exactly the same. You need to forecast the future, make your best judgments and value the company. The problem you have with young companies is those judgments can't be just taken from past date and extrapolating. You can't do lazy valuation where you take the last 10 years and extrapolate them. So you have to be clear about where the difficulty comes from. It's not that it's more that the models have to be different or the value comes from something different. You don't have the crutches you usually have when you estimate the future that you have for mature companies. And that makes people really uncomfortable and they have to deal with that discomfort. If it makes them uncomfortable enough that they say, I give up, then they either have to trade these companies or not buy them. **[13:27] Speaker A:** Nobody puts a gun to your head and says you have to buy SpaceX and OpenAI and Anthropic. **[13:33] Speaker A:** If you don't want to buy it, fine. There are thousands and thousands of beer makers and automakers and steel makers and retail companies that you go put your money in. Stop complaining about other companies because they're so difficult to value. It's none of your business. It's other people's money. They will invest in it or they'll trade on it. They're being greedy. That's their problem. I think we spend far too much time wagging our fingers at other people and telling them how shallow they are and how they shouldn't be investing in growth companies and how they should be dealing with uncertainty. Uncertainty is a feature, not a bug. **[14:13] Speaker A:** The reason it makes us uncomfortable is you're playing God and nobody should be comfortable playing God. **[14:19] Speaker B:** Are there valuation techniques or a special source which you have come around over the years where you say this and that helps me to value, let's say, for example, the chips companies which have these structural tailwinds. Is there anything we can learn from history? **[14:49] Speaker A:** I think there is a very simple lesson. A business is a business, no matter how much hype and buzz you put around it. **[14:56] Speaker A:** Every business ultimately has to do what they have to generate a product or service that people want that they're willing to pay for. Stating the obvious, might as well start with, that's your revenues, right? Then you've got to produce that product and service to sell it. How much does that cost them? That's where I think one of the things that I've learned is to step back from the brink, step back from the buzz and ask the question, what are you making? **[15:20] Speaker A:** What does it cost you to make it? That's unit economics. And how much money can I expect you to make in the future? Those questions don't change young or mature. And I think by going back to basics, I find myself being able to address these questions rather then you know, because otherwise you get caught up in the buzz of, look how many users I have. Look how amazing Claude is. Look at how much, how, how wonderful this product is. You don't, you don't, you don't make money from how wonderful a product is or how great people tell you you are, how many users you have. Ultimately you've got to convert that into revenues and earnings and cash flows. And by stepping back and saying, what is the true business here, you're going to be able to address that much better. **[16:05] Speaker B:** Another topic, valuation topic, which comes up pretty often is GPU depreciation. **[16:14] Speaker B:** So I'm more a credit guy, I'm looking much more on cash flow. So at the beginning I was a bit Surprised that there was so much focus on the depreciation schedule of GPUs because at the beginning it's cash out and then you recoup whatever earnings there are and the depreciation is more or less more for net profit and taxes. But what I then realized, it also drives earnings, right? The less you need to deduct, the higher the earnings and the higher the pe or the lower the PE then looks like. **[16:54] Speaker B:** What are you making out of this GPU question and does it bother you from a valuation perspective? **[17:01] Speaker A:** You know how often I've thought about depreciation in the context of AI? Not a second. This is. This is what happens when accountants enter or people with accounting skills try to value companies which are young growth companies. **[17:19] Speaker A:** Of course depreciation lowers earnings, but depreciation gets added back. Who cares? You know who cares? Lazy people who apply price earnings ratios or ebit, EBITDA multiples, for whom earnings is a big deal. This is exactly why pricing is lazy and sloppy. **[17:39] Speaker A:** And if you play that lazy and sloppy game, you shouldn't be investing in individual companies to begin with or worrying about depreciation. Go buy an index fund and live the rest of your life. So when I see somebody focused in on depreciation being the big issue with AI, my reaction is you're playing the wrong sport. **[18:00] Speaker A:** Move on. So I must confess, I read this depreciation stuff and my reaction is what are you guys doing in here? Why are you wasting your time? This is not the topic. I mean, if you're a mature company, an infrastructure company, you know what? Depreciation does matter. You know why? Because your big capex happens up front. You've built the infrastructure and depreciation becomes the gift that keeps on giving. In fact, it's a good thing. It makes your cash flows higher. So you're validating a toll road. By all means, worry about depreciation value. An AI company. Come on. **[18:37] Speaker A:** There are far bigger fish to fry things to worry about than what the depreciation schedule is and what it's doing to your earnings. Because you completely lost the script if that's your focus. **[18:50] Speaker B:** If you focus on the financing part of AI and data center, the shift is getting more and more depth, focus and a lot more of balance sheet vehicles coming into play, financed mostly by private credit. **[19:08] Speaker B:** How are you thinking about the interplay of credit and equity when it comes to financing AI projects and data centers? **[19:19] Speaker A:** I think there are. I mean when you look at the big tech, the mag seven again, debt is not something I think about. Even Once in the top 100 things that I worry about. But there are these smaller companies that are building data centers that are probably over levered where if the big market or when the big market delusion corrects itself, those companies are going to be exposed because they borrow too much money. **[19:43] Speaker A:** They're like, I mean, I'll give the analogy in a different business. The shale oil companies that went out and borrowed money when oil prices were $120 a barrel that then struggled with bankruptcy and default when oil prices dropped to 60. You know what my bigger question is? Who are these lunatics who are lending money to the data centers? I mean, I think private credit is vastly overrated for intelligence. People assume these private credit guys must be smart guys must. No, they're not. They're sheep. They run after where every other private credit. I mean the, the reality is, you know, every one of these spaces, hedge funds, private credit, private equity, have overreached. **[20:31] Speaker A:** Overreach in what sense? They've taken a solid niche business. Private equity was a solid niche business. Hedge funds were a solid niche investing space. And private credit had its place, which is to lend to people who could not borrow from banks because of structural restrictions. **[20:53] Speaker A:** Banks could not lend to them. You know what they did? They oversold themselves. They took a $200 billion or a half a trillion dollar business and made it 20 trillion. When you do that, guess what happens? **[21:05] Speaker A:** You become sloppy. You attract some really bad actors into your space and you take the overall business and you make it a bad business. Hedge funds 30 years ago had positive Alphas. They earned 3, 4, 5% more than putting your money into a passive vehicle. Today, hedge funds look like mutual funds. They earn about 1.5% less than passive investing. Same thing with private equity. And private credit is just setting itself up for a beating up to happen. And the danger with private credit is they can take others down with them. Private equity can say, hey, what's the big deal? You know, these are equity investors, they know what they're doing. Private credit has a potential to create a lot more damage. And it's always true for any lending business. You overreach, you create social costs, you take others down with you. For me, the biggest loser that I worry about most from the big market delusion correcting is not the equity investors in the AI companies or the big tech companies. **[22:11] Speaker A:** It's private credit. Because I think that's a space where you have no upside. And that's why I said who are these lunatics who are doing it? Because at least I can understand that overconfident entrepreneur who's investing in AI equity because you get upside, you get huge upside. What's the upside to being private credit? That you get your interest even if it's higher paid back? It's a terrible way to run a lending business. It always has to lend to risky businesses when you don't get a share of the upside. But you know what? That trains left the station. **[22:44] Speaker A:** Too many hundreds of billions of dollars at play, often from people who really don't quite seem to understand. The essence of lending is not to lend more, but lend more at a fair rate. For you as the lender, you got to factor in default risk and you have to ask yourself why aren't other people lending? Why do I seem to be the lender of last resort? And you constantly are the lender of last resort. **[23:10] Speaker A:** It's because you're lending at too low a rate. And that's the collective judgment I think we're going to make about private credit in this space. **[23:17] Speaker B:** Very wise words. If you shift more towards the liquid markets, there is core weave. It's relatively clean example I would say and we monitor it relatively closely. **[23:34] Speaker B:** And what is interesting here is that the equity valuation is actually driving the cost of capital and also driving down the cost of debt. So in this case, unsecured debt measured by CDS is trading around 500bps. They also have, as you just mentioned, GPU and contract backed infrastructure debt which is all investment grade. How do you think about this relatively new phenomenon where equity, or rather said the equity narrative is more or less dictating the cost of cost of capital as it also reduces the cost of debt. **[24:19] Speaker A:** You know what? That's the who should be getting the message, right? If you're a lender to a company where the equity narrative is setting what you charge the company, you've lost the script. You've lost the script. I know lenders are considered old fashioned and boring, you know, because you know what you lend on, right? You don't lend on what equity investors think a company's worth. You lend based on cash flows now, not cash flows in the future. You need to be paid now. And the assets that you see out there, people are lending based on equity narratives. I mean, when in lending history has this ever ended well? This morning I got an email from somebody saying SpaceX seems to have very little debt in its capital structure. Should they borrow more? My reaction is are you insane? You have a company that is losing $2.5 billion right now. **[25:17] Speaker A:** Who in their right mind should be lending to that company. I don't care what the market cap is in trillions because you don't benefit from that upside. **[25:26] Speaker A:** So I think that's a very dangerous space to be if you're a lender. If spreads and interest rates are being determined by what the market cap of a company is doing, rather than the current capacity of that company to generate cash flows to service your debt. I mean, you can't make interest payments with potential and promise. You got to make it with cash flows. So, and, and from the other side, if I were looking at Core Week's management and said, what's wrong with you guys? **[25:56] Speaker A:** Why would you go out and borrow money when you are in fact a company with a great deal of promise you can raise equity? Because I've never understood young growth companies that borrow money. In fact, I don't understand the entire area of venture debt. I'll be quite honest, I think it sounds like an oxymoron to me to venture companies borrowing money. I know it sounds lucrative, but it's a terrible idea for both the company borrowing and the person lending to them. **[26:29] Speaker A:** Because you're taking a company where all of the value comes from future growth and promise, and you're putting it at risk effectively because you can borrow money at 6% today. And that violates every single rule in corporate finance. It's just Corporate Finance 101. So if Core Wheat lenders are lending because its market cap is high, they need to re examine how they think about lending because it's not a good place to be. **[26:56] Speaker B:** I think you're bringing up again and again the question that we are in a phase probably of a lot of exuberance and eventually we're going to end up with quite some over capacity, which could be also burdensome given that it's quite a bit debt finance and assets depreciate fairly fast. **[27:21] Speaker B:** One question from my side which is bugging me personally is how do you think about and value companies in industries with structural overcapacity? **[27:33] Speaker A:** I would look at two different groups of companies. You can have overcapacity in a young growing market because you want to cover future growth. That's perfect. Okay? In fact, it can be a competitive advantage to have overcapacity because newcomers are going to look at you and say we're not entering that market. Look at how big the factory is that this company is built to make electric cars. Overcapacity can also come about because your market is shrinking. That's a very, very different and a much more fatal problem. You're a tobacco company and you built a factory to make 5% more cigarettes every year for the next 20 years. And your market is shrinking for 5% a year. You got an overcapacity problem born in hell, right? Because there's no exit from this problem that is going to look good. You can't try to sell the capacity. **[28:23] Speaker A:** Who's going to buy capacity in a market nobody wants your product. **[28:26] Speaker A:** That's a case where you will shrink as a company if you're sensible and try to kind of make the problem as least painful as you can. It's going to be painful no matter what you do. So I think overcapacity by itself is not the issue until you bring in what the market is looking like. So if you have overcapacity in AI, that's fine. That's something that you would expect in a growing market. **[28:55] Speaker A:** But overcapacity in markets which are shrinking, much more difficult to sustain. You don't want to overreach because there's no way back from that cliff. **[29:04] Speaker B:** Another point I want to bring on to which is bugging me. So if you have an industry which is purely equity funded, then it's relatively easy. You have assets which trade below book value below nav and you can acquire them, take them out, reduce. **[29:25] Speaker A:** No, you can't. And I'll tell you why. NAV is an accounting number. For the most part, market values reflect what the market thinks about a business. If you're in a bad business, it's a feature, not a bug that you're going to sell below nav because your assets have lost value. Their assets have lost value because their earnings capacity has dropped off. The notion of book value being liquidation value is one of the biggest delusions we hold on to. Lenders hold on to it. They often lend based on book value, right? They look at a building, there's a equity investors, especially old time value investors. This became the basis their entire investing. Buy stocks that trade less than book value. Because implicit there was this belief that book value actually means something. I'm going to be cynical. All that book value measures is accounting rule. Writers gone crazy. **[30:22] Speaker A:** Essentially it's a reflection of a world that's been left behind. So for the most part I think book value means very little. There are exceptions. One is there are businesses where you have to reappraise the the price of your assets. **[30:40] Speaker A:** Real estate for instance, you can reap there. You can argue that the pricing that you see in the book value is like close to liquidation value. You still have to factor in the cost of liquidation and the taxes you will have to pay. The other is if you're a holding company which has mark to market rules. Softbank, for instance, the holdings it has of public companies have to be mark to market there. Again, you could argue that if I can buy the company below book value, I should be able to sell Alibaba shares, which I own because it's a public market. Again, you still have to factor in the taxes you will have to pay. But in most cases, book value has become one of the least useful metrics you can focus on either as an equity investor or as a lender. They reflect very much a 20th century view of companies where book values might have captured the factories and physical assets. **[31:36] Speaker A:** Book value now is made up of things that accountants have just concocted out of thin air. Right. With fair value accounting, who knows what book value actually measures? **[31:46] Speaker B:** Absolutely, that's a very fair point. I think in your book you also put a lot of emphasis on that intangibles are not really accounted for. And that's why, I guess book values therefore are in most cases relatively useful. **[32:05] Speaker B:** Where I was trying to go to, if you think again about the overcapacity issue, if you have purely equity funded businesses and they come in and buy something at a real discount, let's say a discount to market value prices, or you buy something below the intrinsic value, **[32:28] Speaker A:** let's make it liquidation, let's clean. So you have a company with liquidation values. 100 equity investors come in and get it at 50. They liquidate and clean the 50. You know why that works, right? They get the upside. Lenders come in and do the same thing. The problem is they don't get upset. That's the problem. Right? Lending is asymmetric. Asymmetric in the sense that you get a share of all of the bad things that happen to the company, but you don't get a share of the good things that happen. So I think lenders have to factor that in. They have to recognize they're playing an asymmetric game, which also means that they can't let the equity investors run a business. **[33:07] Speaker A:** If you have heavily levered business, because equity investors are going to take them to the cleaners, they're going to take them to the cleaners because they're going to liquidate assets right from under. You sell them for that upside, pay themselves a big dividend or buy back stock and what are you left with? A company that's a shell of itself with no physical assets left anymore. If you haven't put your claims specifically in the contract. Lenders have, through the history of lending, have always learned that if they don't protect themselves, they will get ripped off. **[33:43] Speaker A:** Somewhere in the last 50 years, I think especially in the bond market and with the kind of lending where it's just based on volume of lending, we seem to have forgotten that lesson. You don't protect yourself, you are going to get ripped off. And the example that you have, you're right, the equity investors will get the upside, but lenders don't. So you got to put restrictions on what equity investors can do or take a share of the equity. That's the other choice you have, right? **[34:11] Speaker A:** As a lender in businesses like this have a convertible bond or convertible debt where you get a share of the equity. Because anytime there's an upside game and you don't share in it, you risk this play where equity investors take advantage of you. **[34:27] Speaker B:** I think that's a good prelude to the next part I want to discuss with you. You've done a lot of work on the life cycle of companies where you also say that financing should act its age. And you just mentioned that if you as a company are not really old enough to have debt, then maybe you should entertain a convert. **[34:51] Speaker B:** But just in both. **[34:53] Speaker A:** It's good for both sides and years, right? Both lenders. And so that's the thing about good sense corporate finance. It's not just good for the company, it's also good for the lender. **[35:03] Speaker A:** So the reason young companies should use converts is it's good for the company. It keeps their cash flows low because the coupon rate and converts are low. It's good for the lender because it allows them take advantage of protected. If equity investors decide to try to take advantage of that. **[35:20] Speaker B:** That's a good point if you just think about it. **[35:24] Speaker B:** Where do you think the most value is destroyed by capital structure design that does not really match the stage the company is in? **[35:36] Speaker A:** I think you just described it. The minute you're a company that doesn't act its age in financing, you're destroying value. That's why I said a young company that borrows money is destroying value. Why? **[35:49] Speaker A:** Because its value comes from future growth and potential. It's putting it at risk by taking the debt because if the debt cannot be paid, the growth potential gets cut off. You got to sell yourself at a fraction of your value if you're a mature company that refuses to borrow money. And here we have to recognize cynically what the value of debt is. The only reason debt can change the value of a company is not because it's cheaper, but because it brings a tax advantage. **[36:21] Speaker A:** Already there are segments of the world where you shouldn't be borrowing money at any stage in the life cycle. You're a mature company in the Middle east. Don't borrow money. Why would you? There's no tax advantage. **[36:33] Speaker A:** Only bad things come out of it. But to the extent that there's a tax advantage, mature companies are leaving value on the table by not borrowing money. So it's not so much value destruction, but value left on the table. So young companies, it's debt overreach, where you put your survival at risk, and effective value. With old companies, it's tax benefits left on the table because you don't borrow enough money. **[36:59] Speaker A:** But at the core of both are companies that refuse to act their age in how much they borrow. **[37:03] Speaker B:** So would you say it's fair to say that probably for most of the growing firms where you also see some private credit involved, they should resort much more to convertibles and not to private credit solutions? **[37:22] Speaker A:** Absolutely. Or not borrow money at all. Let's face it, the reason many young companies borrow money are twofold. One is control. You see where control comes in, right? You're a startup or a young company, you should be issuing equity. But if you issue equity, the founder stake or the VC stake gets smaller and they don't want to go that route. So control is a big underlying story in how companies use debt or misuse debt. **[37:57] Speaker A:** The zeal to be in complete control of a business might mean a young entrepreneur pushes his or her company to the brink and over the edge by borrowing money. The other reason you might borrow money is because your equity markets are not developed, you can't raise equity capital. I talked about the Middle east from a corporate finance standpoint. No Middle Eastern company, especially the parts of the Middle east where you're not allowed to claim interest expenses or tax deduction. Those companies should never borrow money, but many of them do. **[38:32] Speaker A:** One is control. Many of these companies are family controlled, even if they're publicly traded. So they borrow money to not dilute family control. The second reason they borrow money is in much of the Middle east, equity markets are not well developed. You can't go out and issue shares easily. So they borrow money because the equity pathway is being cut off. Neither of those should apply if you're a young tech company where founders are willing to accept dilution and VCs are willing to accept delusion. But you can see why companies, young companies choose to borrow money for Those **[39:05] Speaker B:** two reasons, if you're going on with our aging process and go more towards mature and declining companies. **[39:18] Speaker B:** One of the key learnings I think I found in your book is that default risk is usually a very forgotten factor in valuing companies. **[39:31] Speaker B:** And I think you make the point as well in your book is that usually you think about a large company, they can't, can't default. But also, that is not super true. And I think your argumentation is that usually you should weigh the cash flows by survival probability rather than to raise the discount rate. Why would he say is widening the discount rate the wrong fix if you're valuing more stressed companies? **[40:10] Speaker A:** No, because discount rates are meant to capture going, concerned risk. **[40:17] Speaker A:** So when I have cash flows in year six that I'm very uncertain about and the risk cannot be diversified, I'm going to charge a higher discount rate. But the risk you're talking about is truncation risk. You know what I mean by truncation risk? It's that there will be no year six. That's a blunt instrument that we're talking about there. **[40:35] Speaker A:** And discount rates were never meant to carry that kind of risk, even though people try. I don't actually need to say, you know, try to adjust cash flows. What I actually do is value the company twice. First, I value it as a going concern with a traditional cost of capital and cash flows improving over time. Because that's what going concerns do, is they learn to live as smaller companies and survive. **[41:02] Speaker A:** But if there's a 30% chance of failure, I'm going to ask a different question, which is, if that happens, how much will my equity be worth? Let's face it, in failure, you got to liquidate yourself, you got to sell off pieces. You take those proceeds, and what do you do? You pay off the debt. So this is not a DCF you're doing. You're doing a liquidation valuation. You subtract out the debt, and if you're truly in trouble, guess what's going to be true? The liquidation proceeds are going to be less than the debt. You thank God for limited liability as an equity investor. Why? **[41:35] Speaker A:** Because your equity can hit zero, but it can't go below. And then you walk away. Your equity is worth zero. The 30% of the time you have failure. And the other 70% of the time, I do a traditional DCF. **[41:47] Speaker A:** It deals with failure much more frontally and much more logically and much more easily than trying to slip it into discount rates where it's never meant. I mean, that discount rates were never meant for that kind of risk. **[42:00] Speaker B:** So you would say that it doesn't make sense to really increase the discount rate above a certain level as it doesn't really work. **[42:09] Speaker A:** It's not effective. It's not. You can do whatever you want, but it's not effective. It doesn't work. I mean, valuation is pragmatic. We can draw theoretical equivalence of, say, if I came up with just the right discount rate, would I get the same value? Perhaps. **[42:24] Speaker A:** But I think that from a pragmatic standpoint, when you start to play the discount rate game, you very quickly lose your way. So I'd much rather keep it cleaner and easier. You know what the advantage of having this failure risk then is? It forces me to focus on failure much more directly rather than let it slip into the discount rate. I'm asking questions. Why do some companies fail and others don't? I'll tell you one reason declining companies fail is in decline. Your revenues start to drop off, your earnings become smaller, and if you're sensible, you want to survive as a company. What should be happening to your debt as you decline as a company? It should also be declining, right? So you should be using some of the cash flows you get from the declining business to pay down debt. But here's the problem. If lenders are not watching the store, they're keeping their eye on dollar debt. **[43:19] Speaker A:** Guess what the declining company does? It gets smaller. **[43:21] Speaker A:** It gets the cash flows from selling off businesses. And what does it do with the cash flows? It buys back stock or pays a dividend, which over time gives you this mathematical reality, which is equity will keep shrinking in this business, the debt will stay high and you're going to go bankrupt because your debt reflects a very different company from five, 10 years ago, which was a mature company, which was making money and growing at a reasonable rate. But now it's a declining company, it's lenders not watching the store or not being able to alter this pathway that often causes distress. And that's why focusing on failure risk for both equity investors and lenders can lead to more sensible outcomes for declining companies. **[44:07] Speaker B:** Very wise words. One thing which is bugging me if I'm looking or valuing credit, One thing we usually see is if you're thinking about a performing credit and thinking about how to price it, you have like default probability times loss given default. Very basic. But as we see the credit deteriorating, the payoff is turning very negatively convex and more option like. And at some point, I mean, if I'm thinking from a purely distressed perspective, it needs to give Me quasi like equity, like returns. **[44:52] Speaker B:** But the issue is if you are kind of in that no man's land between where you have this more linear pricing model and you're going more towards that equity like pricing model, it's relatively tough to price that middle ground. Do you have any thoughts about how to approach that from your experience or is that just very, very tough to price that? **[45:22] Speaker A:** No. I'll tell you what, I'm not a fixed income person. I find fixed income to be boring, to be quite honest. **[45:28] Speaker A:** I just. It's not my. But in distressed companies, I talk about how equity at some point in time becomes a call option, which is very much your problem. Looked at from the other side, effectively, this company is actually now underwater, but it's still a going concern. It's able to make its interest payments, but clearly if you force this company to liquidate today, there's not enough money to pay off the debt. **[45:53] Speaker A:** When equity becomes a call option, there's something called put call parity, right? So if equity is a call option, guess what debt becomes? It essentially becomes a put option. So what you have here is the worst of the two options. Because the call options, you're just going for upside. **[46:11] Speaker A:** So you let the equity investors in a distressed company keep running the company. Guess what they're going to do? They're going to increase the riskiness of what they do. Because what difference does it make? You're going to go bankrupt anyway. Might as well go for the greatest upside. And therein lies a lesson for why you should never be a passive lender in a leveraged transaction or a leveraged company. If you're a passive investor in a leveraged company, let the equity investors call the shots. They're going to do what's right for them. It's not because they're bad people and what's right for them is to ramp up the risk in this business because then if it pays off, they get the upside and if it doesn't, they've lost anyway. Right? So my advice to lenders, in very lever transaction, you're right, you're now talking about optionality gone crazy. **[47:04] Speaker A:** And unless you step in, you're going to be on the wrong side of the option. It's not that it's an option, but that you're on the wrong side of the option. You need to find a way to protect yourself and that might require that you take over the company and run it and protect your interests rather than let the equity investors continue to run it. **[47:24] Speaker B:** You are talking, I guess, on the Equity holders really increasing the asset volume of the whole business. **[47:31] Speaker A:** So that the option, right, as you mentioned, an option we know what drives the value of an option is the variance. So it's a natural consequence of optionality. That variance is going to get pushed up by equity investors. They'll benefit from higher variance and lenders lose out because in a sense they've sold the call. **[47:54] Speaker A:** And when you sell the call and increase variance and you've set the price already, you're going to walk away a loser from that process. **[48:00] Speaker B:** If we think about all the costs of distress, so losing customers, worsening or tightening supply terms, something we see very often underinvestment, I think that's very rarely talked about. Usually everybody thinks about their company as running smoothly and investing very, very handsomely, even though it's highly levered. And then if you really open the box, the Pandora's box, then you end up with a situation where the company is actually very under invested. **[48:37] Speaker B:** How do you think about these risks if you think about declining or distressed companies? **[48:43] Speaker A:** With declining and distressed companies, it's less of an issue to begin with. Right? There's no investment to begin with. You're talking about divestitures rather than investments because that's the essence of shrinking. **[48:54] Speaker A:** This is more of an issue with healthy and especially growing companies. And my advice to them on the leverage front is if you're going to make a mistake on debt, have too little debt rather than too much. I mean, so I mean, I do the optimal. I talk about how to optimize your capital structure. It's a very simple process. If you're an equity investor, you optimize the capital structure to minimize your cost of capital. Why? Because by minimizing your cost of capital, you maximize your operating asset value. So let's say you come up with an optimal debt ratio of 30% for your company. It'll reflect your capacity. **[49:30] Speaker A:** In theory, you should go to the 30% because it minimizes the cost of capital. But then I talk to my students about the uncertainty of their estimate. There are lots of numbers that went into 30%. You could be at 35 or 25. And I say if you're going to shoot for a number, make it 15 or 20% rather than 40 or 45%. **[49:49] Speaker A:** It's better to be under levered than over levered because of all of the things you talked about. Because if you're over levered, it's not just your cost of capital gets higher. You create this vicious cycle of having too much debt affects your revenues, your capacity to retain employees. And before you know it, you've spun yourself into distress because you just went. So just going a little bit over the optimal. If something bad happens can put you in a debt spiral. And you want to avoid that debt spiral at all costs, which is again the reason if you're a young growth company with a lot of potential, just don't borrow money. Don't even risk exposing yourself to that debt spiral. It's not worth the payoff in terms of saving that few basis points that you think you're saving. And even that's an illusion. But even what you're saving is not there. **[50:42] Speaker B:** I think there's a lot of discrepancy between how credit investors think about companies and equity investors, obviously. But what I'm hearing quite a lot from credit investors is they care less about whether a firm earns its cost of capital and more about just getting their money back. Put very simplified. **[51:05] Speaker A:** Absolutely right. And that's exactly what they should be thinking about. Am I going to get paid? Am I going to get paid? Credit investors who worry about return on capital and excess returns are completely missing the board. You're not getting any of that upside. **[51:19] Speaker A:** You'd rather that a company take bad projects where the assets are liquid and you could sell them to collect back your debt, than that it takes good projects. That's why bankers should never run companies, because they're going to be focused on the wrong thing, protecting against the downside. But as lenders, that's exactly what you should be doing. At the same time, asking equity investors to worry about you. What you're worried about. **[51:45] Speaker A:** You're asking them to do something that makes no sense. Right? Why do I worry about whether you get paid? To me, that's a side issue. I will try to pay you because otherwise you're a pain in the neck. You step in and you write covenants and you stop me from doing what I'm doing. But to many equity investors, lenders are more pest to be dealt with. That you pay the interest to rather than somebody that you cater to because our interests diverge. It's at the core of corporate finance is what's good for equity investors and what's good for lenders doesn't necessarily correlate. You have different incentive systems from all **[52:24] Speaker B:** your work on valuations. What are two or three mistakes you see most often from sophisticated investors and not from beginners? **[52:39] Speaker A:** In fact, I don't even draw that distinction. There's no such thing as smart or sophisticated money or dumb and unsophisticated Money. We all are human beings. We fall into the same traps. The first is recognize that 95% of investors don't value companies, they price them. **[52:56] Speaker A:** Pick up the Ben Graham security analysis bible for value investors, right? He uses this very basic dividend discount model, which, if you try today, wouldn't even work on 98% of companies. Ben Graham's basis for picking good investments was to attach 11 screens, find companies, low PE, low debt ratios, and I understand what you're doing. You're pricing companies. So the first thing to ask yourself as an investor is, am I really investing or am I trading? There's nothing bad with trading, but it's good to be honest with yourself. If you're trading, what drives your success is are you pricing things right and are you getting out at the right time? The essence of pricing is to buy at a low price, sell at a high price. So most investors who call themselves sophisticated really don't value companies. They price them. Maybe they use a lot more data and their PhDs in science and math doing the screening for them, which is at the core of how many hedge funds got started. **[53:56] Speaker A:** It's not run by people who are great at valuing companies. They're very good at pricing companies. But I think when I do look at people who actually try to value companies, many of them are so focused on the mechanics of valuation that they've lost again, the script of what it is that drives value. It's not the number you estimated for growth or margins or reinvestment. **[54:20] Speaker A:** It's a story you're telling that leads to those numbers. I'm a great believer. In the last 40 years, we've become so good at coming up with these models that valuation has become financial modeling. Financial modeling is not going to work on most companies. If you're truly an investor, let go of financial models. **[54:41] Speaker A:** Use them as tools, but don't let the models run you. The models are supposed to work for you. Focus on business stories you're telling about companies and become better at that, because that's what's going to make you a better investor. **[54:55] Speaker B:** Another thing I wanted to cover with you is you have mentioned it before. You're separating price or pricing from value and valuation. **[55:05] Speaker B:** But if you're thinking about broad selling pressure or simply less interest in equities, I think that it's not a thing of the present, but it has been of the past. And then prices move for reasons unrelated to valuation. How do you keep the two apart in practice? And how long do you think can price and value diverge? Before one forces the other. **[55:35] Speaker A:** Well, there's a pricing effect on value at the market level. Right. If people get scared for whatever reason, what do they do? They sell stocks. They sell stocks, the price of stocks go down. **[55:48] Speaker A:** And if I'm valuing companies in a period where people are afraid, should my value be different? Absolutely. You know where it's going to show up? Through my equity risk premium. It's a number that I estimate every month. **[55:58] Speaker A:** It's my gauge of how. It's my gauge of that balance between fear and greed that's always driven markets. When fear wins out, the risk Premium gets higher. 2008, 2020, during COVID at the start of the tariff announcement last year, start of the IR war, fear is turning out. My equity risk premium goes up. **[56:18] Speaker A:** So that pricing component still affects my value. Because it'd be silly to sit there and value companies saying nothing changes as the world around you is melting down right now. How do you keep the fact that momentum and mood are human emotions? Put simply, if you're valing an AI company today, are you getting caught up in the mood of the moment of AI is going to be made? Of course. **[56:42] Speaker A:** You're a human being. Accept it, right? Don't fight it. I tell people, look, all valuations are biased. They bring your biases in. **[56:52] Speaker A:** All you can do is be open about those biases and say, this is what. And that's why I'm big on telling stories, because you can hide biases behind numbers. But if you tell me a story and I can see it's a big, upbeat story, you're telling me what your biases are upfront. And that's all I can ask of you. You, because you're a human being and you will always be biased. **[57:14] Speaker B:** If a credit analyst and an equity analyst are looking at the same asset, but obviously through different lenses, what is one thing you would want both of them to start doing differently? **[57:31] Speaker A:** I think you all both have to start by understanding businesses. A credit analyst who does not understand how an OpenAI or an Anthropic is going to make money is going to be in trouble. In other words, the core questions I need to answer as an Equity Investor in OpenAI and Anthropic are also core questions that a lender has to answer. What is this business? **[57:54] Speaker A:** What is the business model they're going to use? How will it translate into the things that matter to me? How quickly revenues grow, what margins I will have, what cash flows I will have after reinvestment? The core business questions are the same and You've got to start with our core business questions. Both lenders and equity investors have become again too Excel spreadsheet focused, too financial model focused. **[58:20] Speaker A:** And that's not a good place to be for either group because you're going to miss the big picture and it'll always come to you as a surprise when business models melt down. **[58:30] Speaker B:** That was great Aswad. Where can listeners find more of the work you do? **[58:35] Speaker A:** Just type in my name into Google and you should be able to find my YouTube channel. You should be able to find my webpage so there's no secret receptacle. It's been in the public domain now for 25 years. Some one of the easier people to find because of an unusual name and it's easily findable. **[58:54] Speaker B:** The name helps. Thanks for coming to show asvad and thanks to everybody listening and watching to Fix and Floating the Credit podcast. If you enjoyed this episode, please follow or subscribe wherever you get your podcasts and see you next time.