Welcome to the twenty-seventh Pari Passu newsletter,

Thank you for being a subscriber.

Today, we will learn more about:

1. When To Quit - Book Summary

2. Morgan Stanley Default Outlook

Attention

Pari Passu has moved to Substack.

Please Subscribe there to receive future emails and to find the updated archive.

When to Quit - Book Summary

Today, we will be highlighting the most salient examples, potent concepts, and actionable steps that you can take from Annie Duke’s novel “Quit: The Power of Knowing When to Walk Away.” Duke, nicknamed “The Duchess of Poker” and a prominent decision scientist, offers her perspective on how to decide when to give up, a stimulating topic in a world where endless persistence and resilience are praised in all dimensions of our lives. We listened to Quit on Audible and encourage all of our listeners to do the same for free here*.

Salient Examples

• Mohammad Ali

  • Named the greatest boxer of all time with impressive victories in the 1960s and 1970s

  • Continued to fight from 1975-1981 despite obvious signs of degrading health

  • Incurred many losses to novice boxers and diagnosed with Parkinson’s disease in 1984, which is attributed to the brutal beatings he suffered towards the end of his career

  • “The same grit that helped Ali become such a great champion—admired and revered almost without equal—became his undoing when it drove him to ignore signs that were obvious to anyone on the outside looking in that he should quit.”

• Turnaround times on Mount Everest

  • The turnaround time is a strictly observed time in in which clients need to stop ascending the mountain and need to return to base camp, regardless of whether they reached their intended destination

  • The descent requires more skill than ascending the mountain, with 8x more people dying on the way down than on the way up

  • Three crucial concepts of a climbing plan:

    • 1. Patience is not always a virtue

    • 2. Making a plan for when to quit should be done long before you are facing the quitting decision

    • 3. The turnaround time is a vivid reminder of the most important goal, which is not to summit Mt. Everest but to return home safely

  • The expedition leader and four clients, who did not observe the turnaround time, eventually made it to the summit but died during the descent

  • “Grit is what gets you up the mountain, but quit is what tells you when to come down. In fact, it is the option to turn around that allows you to make the decision to climb the mountain in the first place.”

• Slack

  • Stewart Butterfield first created a game called Game Neverending but was not able to secure sufficient capital for it during the dot-com bubble burst

  • He salvaged one part of the game and made Flickr, which he sold to YouTube for $25mm

  • He then founded a new game called Glitch and poured incredible capital into user acquisition

    • Glitch enjoyed a high growth rate and had enough money, but one day, he decided to end the game and return $6mm of remaining capital to investors

    • He determined that Glitch had insufficient probability of metamorphosing into a unicorn to make it worth preserving

  • Now, he was refine another internal project, known as Searchable Log of All Conversation and Knowledge, which became Slack

    • Slack went public in June 2019 with a market capitalization of $19.5bn and was acquired by Salesforce in December 2020 for $27.7bn

• California High Speed Rail System

  • In 2008, the State of California issued $9bn in bonds to fund the construction of a high-speed rail system that would connect San Francisco and Los Angeles

  • When completed in 2020, it was estimated that the project would have cost $33bn and would generate annual revenue of $1.3bn, according to the CA High-Speed Rail Authority

  • These estimates were later revised to 2029 for initial service and 2033 for completion

  • It was not until 2020 that the CA High-Speed Rail Authority rightfully acknowledged the impossibility of blasting through/building track over two dense mountain ranges

    • Instead of ceasing construction, they started building another part of the track that was already well connected with roadways (“in a move that defies common sense, the plan is to keep building without addressing the issues that will eventually be responsible for at least 80% of the cost of the bullet train”)

• People often think that the only way to recover or justify already paid costs is if they continue on

• Alphabet’s X System of Quitting

  • X is an innovation hub owned by Alphabet that is dedicated to making an impact on the world’s most intractable problems in a 5-10 year time horizon

  • X uses the mental model of monkeys on pedestals to decide whether or not to proceed with an initiative

    • Your goal is to train a monkey to juggle flaming torches while standing on a pedestal in a public park

    • There are two parts to this goal: training the monkey (the bottleneck) and building the pedestal (the bait)

    • There is no point in building the pedestal if you cannot train the monkey, in fact, pedestal building merely creates the illusion of progress (people have known how to build pedestals for thousands of years)

  • Project Foghorn intended to convert seawater into fuel

    • Engineers successfully developed the technology and partnerships to extract seawater and process it at sufficient capacity

    • However, the cost per gallon of the resulting product was uncompetitive ($8/gallon), and the project was shut down

  • It is a win if you are able to cut your losses earlier than you otherwise would have

    • This frees your attention and resources to more fruitful endeavors that generate a higher expected value, reducing opportunity costs and pushing you towards where you actually want to go

Potent Concepts

• Quitting has a negative connotation - people are scared to make this decision and avoid it

  • We remember the stories of people who valiantly persevered through hardship, regardless of success or failure in the end

  • We learn to get better at things from experience, either our personal experiences or by watching others, and our ability to learn from experience can only be as good as our memory of them

  • Thus, it is challenging for us to learn to quit when stories about people who quit are rare and typically blanket in sentiments of cowardice

• We are focused on accruing certainty when we should be focused on accruing value

  • The desire for certainty calls us to persevere, because perseverance is the only way to know how everything works out

  • We are lured to persevere not because it is the best decision but because we want to know

  • The only time you can be sure you should quit is when it is no longer a decision you can make

• Quit while you still have a choice

  • If you quit on time, it will not seem like anything dire is happening

  • Quitting is a problem of being able to glimpse into the future and evaluate the range of ways a certain scenario may play out poorly

  • Because of our aversion to quitting, we tend to rationalize away the present clues that indicate how bad things are

  • When people quit on time, it will usually feel like they are quitting too early, because it will be long before they experience a close call

• There is an asymmetry between when we want to walk away and when we want to gamble

  • When you are ahead, we do not want to infuse luck into the equation in the fear that the added uncertainty will eliminate our gains

  • When you are behind, you are more likely to take a gamble in the hope that the added uncertainty will eliminate our losses

    • It is only when we are losing that we want luck/uncertainty to be involved

  • The emotional impact of a loss is double the corresponding impact of an equivalent gain, a phenomenon known as loss aversion

  • People will generally forgo additional profit to secure a guaranteed win

  • We typically do not select the option that gives us the maximum expected value, we select the option that gives us the minimum expected loss

• Kill criteria allow us to spend as little time as possible on the things that are not worthwhile and as much time as possible on the things that are worthwhile

  • Kill criteria combine a start and a date

    • You decide a certain objective, measurable condition, or benchmark and when this should be achieved by

  • Because of the endowment/IKEA effect, we are often blind to the faults in the things we have created ourselves, including products, careers, relationships, homes, etc

    • The people who make the decisions to initiate something should be different from the people who make the decisions to terminate something

Actionable Steps

• Identify the hard part and tackle that first to avoid false progress

• Think about the conditions in which you would quit well in advance of having to face that decision down

• Create pre-commitment contracts and kill criteria

• Three steps to thinking in terms of expected value:

  • 1. Ask yourself whether the course of action you are considering has a positive expected value

  • 2. Compare that expected value with the expected value of other options you may be considering

  • 3. If you determine that another path carries a higher expected value, then walking away from the path you are currently on and switching to the new one will get you to where you want to go faster

    • Expected value tells you whether any option you are considering is most likely to be negative or positive in the long run and provides a basis for comparing different options

• Ron Conway’s (prominent venture capitalist) Quitting Approach:

  • 1. Let them know that you think they should consider quitting

  • 2. When they push back, retreat and agree with them that they can turn the situation around

  • 3. Set very clear definitions around what success is going to look like in the near future and memorialize them down as kill criteria

  • 4. Agree to revisit the conversation and, if the benchmarks have not yet been met, have a serious discussion about quitting

We would like to close our summary with one of our favorite quotes from the book, “If we quit something that is no longer worthwhile, that is a success, not a failure.” Continuing on a fruitless path because of the money, time, and energy we have already invested is a common failure. Think of how many times you have persevered through the remainder of a boring book or podcast because you paid for it or were halfway through already. Audible facilitates these quitting successes and makes it easy to accrue value from the content you enjoy most. Sign up for a free trial here, and unlock unlimited access to Audible’s collection of books and podcasts for a month. This means that you can explore their portfolio with the confidence that higher-value alternatives are only a few clicks away if your current selection falls flat. Stay tuned for future summaries.

Morgan Stanley Default Outlook

On June 21, Morgan Stanley Lev Fin Team published an interesting research report, let’s see here the key takeaways. Following the June 14 rate pause, Morgan Stanley economists believe that the Federal Reserve has concluded its rate hikes for the time being. They anticipate that policy rates will be maintained at the current level of 5.1% for an extended period, with the first 25 basis points (bps) rate cut expected in March 2024.

According to MS, the current macroeconomic landscape may not immediately pose challenges for the credit market. However, over time, below-average growth and interest rates are expected to dampen cash flow generation and drive up interest expenses. As a result, borrowers will need to achieve stronger earnings growth or reduce interest costs. This adjustment process may prove to be challenging, particularly for smaller and lower-quality companies. With limited options for voluntary deleveraging, maintaining the status quo in terms of earnings and funding costs could result in restricted market access, especially as refinancing pressures intensify.

As a result, MS projects a significant uptick in defaults. They anticipate that 2023 will be a transitional year, transitioning from the exceptionally low default rates experienced in recent times to historical averages. The effects of past rate hikes and approaching debt maturities are expected to materialize in the first half of the upcoming year. ~$5.30tn in public bonds and loans are set to mature through the end of FY2025, or ~25% of the market. As a result, MS projects 4.5% and 5.0% for US high-yield bonds and between 5.0% and 5.5% for leveraged loans by the second quarter of 2024. MS believes the default cycle will exhibit three distinctive characteristics. Firstly, they anticipate a gradual accumulation of stresses, leading to a more persistent and prolonged wave of defaults similar to the early 2000s cycle. Secondly, stressed borrowers are expected to increasingly adopt distressed exchanges and restructuring strategies as a means to gain additional time. Particularly in the leveraged loan market, where sponsored borrowers are prevalent, they anticipate debt-for-equity exchanges to play a significant role. Lastly, lower recovery rates and more varied outcomes are projected, even for lenders and investors holding the same seniority level. This is due to the fact that not all lenders can participate in distressed exchanges, leading to a dispersion of results.

1H2023 Trends

The period following the Covid-19 pandemic, characterized by ultralow interest rates, witnessed historically low levels of defaults, particularly in the loan market. However, default rates have since increased significantly. According to MS, 8 defaults were recorded in the high-yield (HY) index and 11 in loans during 1Q2023. Year-to-date (YTD), the default rate stood at 3.3% in high-yield (HY) credit and 3.0% in loans (as of May CY2023), marking a 1.00% - 1.20% increase. Both measures are projected to surpass long-term averages by 2Q2024.

Despite a similar pace of defaults, loans are experiencing higher default momentum compared to their historical standards. The estimated index default rate for loans already falls within the 70-80th percentile range of the 2018-2023 period. In contrast, the current default rate in the HY market remains below the average level observed over the same five-year period. This divergence can be attributed to the higher sensitivity of floating-rate heavy capital structures to the prevailing higher-for-longer interest rate environment. Additionally, the Fed’s Senior Loan Officer Survey (SLOOS), which measures the tightness of lending standards and serves as a leading indicator to default rates, has also ticked up significantly in 1H2023, partially due to the banking sector stress following the SVB failure.

Distressed Exchanges

The current default cycle has highlighted the growing importance of distressed exchanges (DEs) as a key theme. DEs refer to credit events where existing debt is exchanged for new securities and/or cash at a diminished value, resulting in losses for creditors. Importantly, these exchanges allow the issuer to avoid a hard default, such as bankruptcy or payment default.

DEs have become increasingly prevalent in both the high-yield (HY) bond market and the loan market. Since CY2022, approximately 60% of HY index defaults and close to half of loan index defaults have taken the form of DEs. In the HY market, DEs have been a significant part of defaults for a considerable period, accounting for nearly half of all defaults over the past 10 years. However, DEs have gained traction more recently in the loan market, and they have almost become as common as bankruptcies among loan defaults.

One reason for the rise of DEs in the loan market is the heavy presence of sponsors. Private equity (PE) portfolio companies, which often rely on loans, can face challenges during difficult times due to high levels of leverage and sensitivity to interest rates. As a result, sponsored names have shown higher DE rates compared to non-sponsored companies. This trend is expected to continue if weak earnings and tight funding costs persist for several more quarters.

There are three main types of DE transactions: debt repurchases, debt-to-debt exchanges, and debt-to-equity swaps. In the HY market, below-par repurchases and debt-to-debt swaps have been the common types of exchanges, collectively accounting for the majority of DEs completed since CY2022. On the other hand, loan restructuring often involves amendments, such as amend-and-extend transactions, although debt-to-debt exchanges have been dominant in recent times.

Sponsors, seeking to push the boundaries of covenants and permissive amendments, are introducing more creative and complex approaches to restructuring. This has been abetted by the rise of covenant-lite high-yield debt (we will dedicate a future newsletter to this topic), a type of debt that has maximum flexibility and minimal constraints for the borrower, often resulting in only one or even no covenants. One such strategy is known as “priming”, where debt is incurred at the expense of existing lenders by subordinating their claims (Serta was a famous example, we talked about it here). One strategy involves asset drop-downs, where collateral that is “encumbered” (an asset that has a claim on it) is transferred to an unrestricted subsidiary, allowing the issuance of new debt secured by the same assets. This creates new secured debt capacity on existing assets. An example is the case of Revlon, which completed a distressed exchange in 2020 and transferred intellectual property as collateral to raise new debt.

A concerning trend in the current default cycle is the rise of "re-defaults," where companies default again after a previous credit event. Many of the recent default events are actually re-defaults, indicating that previous exchanges or restructurings failed to provide sustainable solutions to the companies' balance sheet problems.

Re-defaults have occurred more frequently in this cycle, with nearly 40% of defaults in the past year associated with companies that experienced a past credit event, almost double the historical frequency. Among the re-defaults in the current cycle, the majority had previously defaulted through DEs, suggesting that the prior exchanges failed to provide sustainable solutions. About 30% of defaulting companies in the current cycle had executed distressed exchanges within the past five years. On the other hand, repeated defaults after bankruptcy filings are relatively rare, accounting for only 8% of defaults that had experienced hard defaults previously.

The probability of re-default is understandably higher among companies that underwent DEs. Based on the sample of index-eligible defaults, around 38% of DE names end up defaulting again within the following five years. These companies, in financial distress, opted for quick fixes like maturity extensions to avoid immediate default pressure, but the exchanges did not provide lasting solutions to their balance sheet problems and did not prevent further restructuring in the future. In comparison, the rate of re-default is significantly lower for companies that filed for bankruptcy, although the methodology used may introduce a downward bias. It is also worth noting that among these bankruptcy filers, the follow-up defaults are more likely to be hard defaults.

Overall, Morgan Stanley believes that the slow buildup of stresses suggests that the default wave could be more prolonged, resembling the extended cycle of the early 2000s. Distressed exchanges and restructuring strategies adopted by stressed borrowers are anticipated to play a more significant role, particularly in the leveraged loan market, where sponsored structures are prevalent. This, in turn, has implications for recovery rates, which are expected to not only be lower but also dispersed across different names and lender types.

First time here? Subscribe for free to receive future emails.

Interested in our reading list? Check it out here.

Looking to partner with PP? Complete the form here. 

Do you have any feedback? DM us on Instagram, we will get back to you!