Jonathan Lewinsohn – Credit Microcycles at Diameter (EP.484)

What It Covers

Jonathan Lewinsohn, co-managing partner of Diameter Capital Partners managing $25 billion across credit strategies, discusses credit microcycles driven by technological disruption and policy volatility. He covers private credit evolution, AI's impact on software lending, housing market dynamics, creditor competition, insurance-driven investment grade markets, and specific opportunities in telecom, chemicals, and healthcare services.

Key Questions Answered

• •Credit Microcycles Framework: Best distressed opportunities emerge when entire industries with high debt loads face technological transformation or policy volatility simultaneously. Historical examples include energy in 2015-2016, California power crisis, mall-based retail disruption by Amazon, and current cycles in telecom, housing, and software. These create buying opportunities in fundamentally sound businesses that need capital solutions to navigate temporary industry upheaval rather than permanent decline.
• •Software Lending Risk: Direct lending portfolios contain approximately 30 percent exposure to software companies, concentrated in supposedly defensive areas like cybersecurity. Legacy on-premise software providers face disruption from cloud-native competitors and AI solutions that standardize data and workflows. Diameter maintains sub-10 percent software exposure in direct lending, focusing on companies where AI cannot easily replicate functionality or where businesses can participate in AI adoption rather than be disrupted by it.
• •Housing Market Dynamics: Existing home sales dropped from 5-5.5 million annually to 4 million, with approximately 3 million representing nondiscretionary moves from deaths, divorces, and mortgage-free homes. Only 1 million discretionary moves occur annually versus historical norms, creating a coiled spring effect. This freeze stems from homeowners locked into 3 percent mortgages unable to trade for 7 percent rates, reducing American labor mobility and economic dynamism significantly.
• •Private Credit Evolution: Direct lending represents top-of-capital-structure lending to sponsors for M&A transactions, while capital solutions addresses 2021-2022 vintage deals with unsustainable debt service coverage ratios. Quantitative analysis shows those vintage deals had higher leverage and lower debt service coverage than current deals, creating secular demand for junior capital to bridge refinancing gaps. Asset-liability duration matching post-financial crisis transformed private credit from hedge fund strategy to sustainable asset class.
• •Return on Invested Capital Focus: Credit investing starts with identifying good businesses through return on invested capital analysis, taking tax-affected EBIT divided by property, plant, equipment or five-year average capital expenditures. Businesses earning strong returns typically have structural advantages like limited competition or distribution monopolies. This equity-like underwriting approach differs from traditional credit analysis focused solely on capital structure positioning, reducing losses from deteriorating business fundamentals.
• •Insurance-Driven IG Market: Annuity product growth creates demand for investment-grade-like assets yielding 50-200 basis points above traditional IG through illiquidity premiums matched to long-duration liabilities. The risk emerges in structured products creating senior tranches for insurers while leaving residual stumps offering mid-teens returns without near-term cash flow. These stumps accumulate in special situations funds and interval funds where investors may not understand extended periods without cash distributions.