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November 17, 2022 05:32 PM

Arena's Dan Zwirn sees tough times ahead and that's just fine

Douglas Appell
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    Dan Zwirn

    October's better-than-expected U.S. inflation numbers, released Nov. 10, found many investors anticipating the fight to contain rising prices would soon turn a corner. Daniel Zwirn wasn't one of them.

    "It's early," probably the proverbial third inning of a nine-inning game when it comes to "the effects of increasing inflation and the rate increases (and fiscal cuts) that will ultimately be required to mitigate the damage," said Mr. Zwirn, the CEO and chief investment officer of Arena Investors LP, a New York-based special situations credit boutique with roughly $3.6 billion in assets under management, in a recent interview.

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    The market response to the 7.7% October rise in consumer prices from the year before, down from 8.2% in September and lower than economists' average estimate, suggested a more optimistic mindset among investors. The S&P 500 that day surged 5.5% to 3,956.37, its strongest one-day gain in more than two years, while the Nasdaq Composite jumped 7.4% to 11,114.15. The Dow Jones Industrial Average advanced 3.7% to 33,715.37.

    That leaves Mr. Zwirn in familiar territory, at the pessimistic end of the market sentiment spectrum.

    Mr. Zwirn, who founded Arena in 2015, has been warning for years that overly aggressive monetary and fiscal policy was creating a financial house of cards. This year's ugly turn for markets — with spiking inflation igniting an aggressive rate hiking cycle by central banks — hasn't forced the firm to review its business strategy, he said.

    Instead, "the environment has come into line with my thinking," Mr. Zwirn said.

    That hardly makes him a Nostradamus, Mr. Zwirn said. The arithmetic of how markets work simply made it inevitable that the "completely unnecessary quantitative easing started in 2012" and put into overdrive in 2020, combined with "grossly irresponsible fiscal policy," would result in escalating inflation, he said.

    On that score, he contends, markets would have desperately liked to see a Republican sweep in the U.S. midterm elections on Nov. 8, as gridlock — with Republicans in charge of Congress and Democrat Joe Biden's term as president extending through January 2025 — would limit the potential for further "grotesquely profligate spending."

    More broadly, investors on the lookout for market-friendly policy pivots anytime soon are likely to be disappointed, he said.

    If some market players still hold out hope that "once risk-free gets to 4.5%, inflation will come back down … that's totally not going to happen," Mr. Zwirn said. "It doesn't take into account the fact that quantitative easing basically gives you another … 300 to 500 basis points of risk free that needs to get worked out," he said.

    The punchline? "I think there's a lot of downs relative to the upside from here."

    If the market outlook is grim, however, the prospects for Arena's private credit lending business is anything but.

    Arena has eight business units – North American corporate; real estate; structured finance; global capital markets; European illiquid; Asia-Pacific illiquid; natural resources; and secondaries and liquidity solutions — and in each "there are exceptional things that we're pursuing" now, Mr. Zwirn said.

    From a credit perspective, trillions of dollars went into growth-oriented enterprises that systematically sacrificed profitability to boost revenues in pursuit of escalating valuations. That left those companies in a box when that growth didn't show up, he said.

    Now, with the collapse in those capitalizations, a capital provider such as Arena can be "a beneficiary of (those enterprises') desperation not to price their equity," coming in way senior, super low loan-to-value, with considerable potential to extract high yields, Mr. Zwirn said.

    The opportunities Arena is finding now for all eight business units, ranging from "kind of tactical, to already happening, and then on the way," have become far more numerous over the past year, he said.

    In many cases, it's an "enterprise, or an asset, or an area or a team we've been following for years and we've both been saying, hey, love you but nothing to do. And then it's like, they call us or we call them and we gotta run, right? Here it is, we gotta get out there," he said.

    On the tactical side, an example of the opportunities thrown up this year as equities quickly fell into bear market territory has been convertible bonds.

    When the "convert market kind of exploded" early this year as the shares of major issuers such as tech companies led the way down, "institutional owners of the converts sold but meme owners of the stock didn't react nearly as dramatically," creating free upside for investors who bought the convertible bonds as well as puts on the underlying stock, Mr. Zwirn said. "We did a bunch of that," he said.

    The biggest opportunities coming down the pike for Arena will be found in the leveraged finance space, as the market's new math puts a stop to financial buyers paying 13 times for an eight times business, Mr. Zwirn said. Similar opportunities will present themselves in mortgages and asset-backed securities, he said.

    The entire game of "I over-lend … at too high a multiple, to finance a private equity buyer's too high a multiple acquisition is now over because it was completely dependent on accessing financing that itself was dependent on issuing collateralized loan obligations, which were themselves dependent on the ready availability of AAAs and people willing to buy other people's CLO equity at incredibly tight expected returns," he said.

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    New secondaries business

    Mr. Zwirn, meanwhile, pointed to the secondaries business Arena just launched in September as an "exceptional opportunity" he'd been eyeing for five or six years, for which the stars just came into alignment this year.

    He said the firm found the right person in Vijay Rao, a director at New York-based secondaries firm LSV Advisors LLC, to build a business that looks at secondaries more as an origination channel than as an asset class.

    For many big secondaries players, Mr. Zwirn explained, the focus is on buying exposures to established private equity funds at some discount from limited partners, for example buying Warburg Pincus' 2017 vintage fund at 92 cents on the dollar.

    For Arena, by contrast "what's systematically compelling throughout cycles is that there are, particularly in the lower quartile of fund entities, lots of opportunities to ... buy various forms of scraps of partnerships that are seasoned and people don't care anymore and they're line items and someone's got to kind of take the trash out and there's lot of returns in that," not unlike buying non-performing loans, Mr. Zwirn said.

    The other opportunity for Arena in that secondaries segment is in providing funding for smaller general partners who might, for example, have one or two winners in a portfolio with five losers, enabling them to extract those attractive assets from the partnership.

    The number of asset owners looking to trim their private equity exposures now is on the rise, following the dramatic drop in the value of their equity and bond holdings this year, Mr. Zwirn noted. Some of those asset owners looking at their private equity exposures are saying "wow, these haven't been marked down yet, I should lighten up on this stuff," while others are reaching the same conclusion because they've found themselves overcommitted to private assets, he said.

    "It's still early but you should be working hard on the opportunity right now because … it's going to be a tsunami," Mr. Zwirn said.

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    Drawdown fund

    On Aug. 1, Arena announced the closing of its second drawdown fund — the Arena Special Opportunities Partners II — at $930 million, a figure included in the firm's $3.6 billion total at present.

    But unlike firms that take a sequential approach to investing such funds, Mr. Zwirn said Arena allocates "across our different balance sheets on a multistrategy basis," which in addition to Arena's first and now second drawdown funds includes permanent capital, open-ended structures that are still asset-liability matching, certain separately managed accounts and funds of ones, as well as excess capacity pools such as the firm's New Zealand credit fund.

    When the recycle period of Arena's first fund closes at the end of 2022, the firm will begin moving toward a first close for its third fund in early 2023, at which point it would be making investments from the firm's second and third funds at the same time, he said.

    For the second fund, Arena's clients were mainly insurers and family offices but, Mr. Zwirn said, the firm was able to garner its first small contributions from endowments and foundations, superannuation funds and pension funds — a tougher universe because the highly opportunistic nature of Arena's funds poses a challenge for clients "struggling with, 'is it my private debt bucket? My this bucket? My that bucket?'"

    But with big private markets firms raising money recently for funds "that basically do anything that makes sense" — he cited Los Angeles-based Oaktree Capital Management's success in converting its distressed debt fund to an opportunistic fund and New York-based Sixth Street Partners' opportunistic Tao funds — Mr. Zwirn predicted Arena's next fund could attract growing interest from pensions funds.



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