Stewart:

Welcome to another edition of the Insurance AUM Journal podcast. My name is Stewart Foley. I'll be your host, standing with you at the corner of insurance and asset management to talk about opportunities across the entire private credit spectrum with three senior folks who are very, very well versed in this space. And I'm going to introduce them one at a time and then we can all chime in. Andrew Kleeman, senior managing director, head of corporate private placements at SLC Management. Andrew, welcome.

Andrew:

Thank you.

Stewart:

Chris Wright, managing director, head of private markets at Crescent Capital. Chris, welcome.

Christopher:

Thanks, Stewart. Thanks for having us.

Stewart:

Absolutely. We're very happy that you're here. John Bowman, managing director Crescent Capital. John, how are you?

John:

Good afternoon, Stewart.

Stewart:

The guy who always learns the most out of these deals is me, because I get to interview really senior people who are at the top of their game in these various asset classes. What would really be helpful and my questions come from genuine curiosity, can you provide a high level overview of the IG and below IG private credit market? And talk about the opportunity set just broadly?

Christopher:

Sure. Sure. I can kind of kick off. This is Chris Wright. Great question. Look, I think, we, and I'll refer my comments specific to the below investment grade corporate credit market, which is where we focus at Crescent. There are a number of drivers and a number of secular tailwinds that are fueling the market right now. Certainly the amount of dry powder that's in the hands of private equity sponsors sets up for a very nice, robust M&A market as we look forward. We're also seeing significant activity for private credit lenders as banks continue to decrease their focus on lending, creating opportunities for us to invest up and down the capital structure in senior, as well as junior and even preferred in minority equity investments, alongside private equity sponsors. If they continue to get out, private lenders like ourselves are filling that void and that's creating a tremendous tailwind.

Christopher:

I think as well, sponsors are really recognizing the value of having private lenders in their capital structure. When you go through a period like we just went through with COVID, it's important to understand that having good partners in your capital structure, allow you to adjust to quickly moving activities that may impact their portfolio.

Stewart:

One of the things that you often hear with regard to differences between public and private, so public versus private, we can talk about being negotiated. The thing that most people think of when they hear private is a liquidity give. At least my experience is that insurers tended to say, "Boy, we need a lot of liquidity," but they really didn't need as much as they thought, perhaps. Can you talk a little bit about public private and the liquidity tradeoffs and whatnot? I think that's something that matters to insurance investors.

Andrew:

Yeah. This is Andy Kleeman. Two things, one is most life insurance companies and even P&C or other types of insurance companies, probably aren't going to liquidate their entire portfolio in a given year, unless something really tragic has happened. Speaking from the perspective of a life insurance company, if you have a $10 billion fixed income portfolio and a quarter of that is in privates that can earn anywhere from 30 to 70 basis points of illiquidity premium and for the investment grade private placements, that's the same capital charge that you're getting on your public A and BBB rated public bonds, all that additional yield falls to the bottom line year in and year out.

Andrew:

Is it at the expense of some illiquidity? Sure. But again, I don't know if anyone actually turns over their entire investment grade bond portfolio in a given year. And to counteract that illiquidity, we have covenants which protect us from the downside and you get a more diversified portfolio. Frequently you get collateral, but the loss history in investment grade private placements is superb. Better than public bonds, frankly. It's kind of a no brainer to add when you're looking at any kind of allocation optimizer between publics and privates.

Stewart:

We talked a little bit about the reduced volatility. I think the consensus is we've got lower for longer interest rates for the foreseeable future. And there's increasing pressure on insurers to generate investment income by getting creative and looking at asset classes that they might already may not have previously. Are you seeing flows? Are you seeing demand to privates versus publics, generally speaking? That's my sense of where money is going, but you guys are a lot closer to it than I am.

John:

I'll touch on that. This is John Bowman. I think as Chris mentioned, the early driver of private credit was in fact sort of the banks exiting and being consolidated and leaving a huge space or void in the delivery of private credit, particularly on the senior side. As we got into that lower rate environment, Stewart that you mentioned, which first came after the last recession in 2009, 2010. With LIBOR very low, you really needed to, I guess it was for Chris and I, the first search for yields dynamic, really coming supercharged. And here we are ten years later through a second event, the pandemic. And once again, the search for yield is now even more pronounced.

John:

And so during that period, absolute returns have come down and the need and the value of getting that extra yield is now more important than ever. And so the flows into the space are significant, whether it's senior capital, junior capital, large cap, small cap, the flows are very, very significant. And then as Chris said, the product is now been delivered privately for a number of years where the private equity community and the other issuers are accustomed and prefer generally a private execution, particularly in the non-investment grade side. You have kind of the perfect storm right now, away from the pandemic, of course, in terms of both capital flowing in and the need for private credit and yield really driving the space.

Stewart:

And I guess in spite of those flows, I get the sense that sometimes insurers are not sold on the asset class. Do you think they are? And can you talk a little bit about the hurdles that clients need to get past? I think maybe it's getting rid of some old thinking and looking at today's current market with a fresh brush. Can you talk a little bit about the kind of hurdles that clients need to get past when they take a look at this thing for the first time?

Andrew:

I think on the investment grade side, part of it is clients, when we describe an investment grade private placement as more diverse, issuers that aren't in the public market, covenants, spread premiums, smaller working groups, better loss. The question comes, why would anyone issue in that market if they're paying a 50 basis point premium over public? And part of that is just explaining the types of deals we do and the structures that we do. And there are entities that are private companies that want investment grade profiles, but don't want to make their financials public.

Andrew:

There are certain entities like accounting firms and such who don't have access to the public market because they want to closely control who holds their debt. They don't want to have any of their clients holding their debt because of the conflict of interest. There are certain structures where maybe an issue or tranche is less than $300 million, so it doesn't get index eligibility. And so there's no pricing advantage to go to the public market. It's not more risk in the private market, it's just a lot more work underwriting and originating and the operational aspects of getting through the deal legal mechanics.

Christopher:

I was just going to add a couple things for the below investment grade market. I think, look, on where we operate below investment grade, it's what I would call the spicier end of the market. And not all private credit managers are created alike in our space. And so we have obviously seen a big growth in this end of the market over the last five or six years, but there are a number of us that have been out there for 20 years and have long track records and can be easily evaluated. I think, number one is really getting to know the manager and making sure you're comfortable with their default history and their recovery history and their loss history and their ability to generate returns. I think the second thing in our market is liquidity versus illiquidity. What we have found is liquidity sounds great, but when you want it, even in the syndicated markets, when you want it, it's not there.

Christopher:

And so we have certainly been on an education course with groups and talking about that and offering insights into how we think about liquidity and that there should be position in your portfolio to generate the incremental yield that we're able to deliver, albeit maybe at a small cost of illiquidity. But I think, that is another area that is sometimes a hurdle. And then the third area that we spend a lot of time with insurance companies on is risk based capital. There's been a lot of technology over the last few years to address risk based capital. Whether that be commingled funds, whether it be getting ratings, whether it be doing an SMA, whether it being a rated note structure, we try to be flexible, just like we offer a solution for the sponsors that we're investing with in their buyouts. We try to address and offer solutions for our investors as well and try to be flexible with the broad platform that we have.

Stewart:

It's interesting just to kind of look at the capital charge. For example, there's a lot of things that we talk about on this show, and on our website more broadly, that are so narrow. It's all insurance asset management. And so the capital charges really matter. And you guys manage money for insurance companies and you get the joke on that and you understand. The thing that Andy said earlier is that insurance companies are often buy and hold. You're not seeing people blow out of an asset class and come back in it, it doesn't work that way. That seems to be a good fit to going down in liquidity. Am I on target there? Or am I off base?

Andrew:

You're absolutely on target. For the investment grade private credit market, we estimate it's probably somewhere around a trillion dollars of outstandings. And it's hard to get a number on that because it's of course, private. And there's a lot of deals that we wouldn't know were done. I think two to three billion a year actually trades. People hear that there's a kind of a pucker factor, but it's because the insurance companies that hold these assets feel this goal. They appreciate the covenants. They value the covenants and the downtime protection. They want to earn that illiquidity premium over time. And so when we do see good credits come into the secondary market, they trade well for the most part. Every situation is unique based on how many investors are in a deal and how that credits performed, but I think illiquidity sometimes is overstated and it's something that the major players in this industry aren't concerned about at all.

Christopher:

I'd also add, when we look at it in a number of our structure, our commingled funds and obviously there's been a growth in the secondary markets of LP interests there's some trading in everybody's funds. But what I would say to your point is, I don't remember the last time senior requests by an insurance company to trade a secondary position out of one of our funds. We'll see it every once in a while with endowments or foundations or sovereign wealth or pension plan. But I don't remember the last time an insurance company went in and was looking to move its position in the fund. It sort of speaks to that point that when they do come in, they are long term investors, they have long-term liabilities and obviously that matches up very well with a longer term investment that can derive higher MOIC and can offer the premium that we're talking about here.

Stewart:

We've talked a little bit about mainly life insurance companies and this is just my own curiosity. What's the business mix P&C to life? My understanding from what I've heard is that P&C companies are beginning to show up into a market that heretofore has been pretty much exclusively the life industry. Can you talk a little bit about that? If you're seeing flows out of P&C space too?

Andrew:

In my side, it definitely is starting to happen. And again, it's just a search for yield. It's been a nice change because we're seeing historically it's been 10 year fixed rate deals and there's flexibility, but it'd be set into the seven to thirty year fixed rate bullets, or sometimes amortizing structures. And with more P&C companies in the market, we're seeing more demand for shorter deals, three to five years, three to seven. And so it's bringing more issuers to the market and it's allowing the investment grade private credit market to be a more bespoke solution to those issuers. It's been a positive having that demand in the market.

Stewart:

Yeah. That makes total sense to me. We talked about IG, we talked about below investment grade. How do they work together? Oftentimes insurers, they're going to have some of each. Do they complement each other? Or are they in competition? Are they completely separate? How do you guys view the IG versus below IG interaction?

John:

I would say what we're seeing is a lot of our clients, whether it's on the liquid side or the IG side, are using privates to just blend up that ultimate yield on their portfolio. When flows started to first come in in a meaningful way after the 08, 09 downturn, when rates were low, I think in the early years, some folks thought of private credit, particularly on the senior side as it might've been an opportunistic temporary need for that extra yield. And then here we are ten years later with LIBOR at less than 25 BPS and maybe it's not so temporary. And I think what that's done is transition insurance companies, I know on the below investment grade side to gravitate their thinking to “no, this is a permanent part of my asset allocation.” In fact, when I got in early, I might have been in the two percent to five percent area, but now I'm moving up with many insurers to five percent to 10 percent of their asset allocation into a below investment grade private credit.

John:

I think as people have become more comfortable with the asset class, and as Andy has said, you get used to the nature of the transaction. People are saying, "Yeah, I do have adequate liquidity so I don't need this portion of my cap structure to be or my portfolio to be liquid and monetizeable and it should really be a permanent allocation. And then I can shift between different markets within private credit." Which is one of the things we at Crescent can really do quite well and why the SLC Management/Crescent transaction, I think it's really interesting.

Andrew:

I would add on that. I think that the investment grade private credit is a great gateway drug to the below investment grade for insurance companies that are looking to understand illiquidity, because on the investment grade side, you get the same capital charges. And you're getting a yield pickup. And then once they've been doing that for a while and they get comfortable with how much illiquidity they can handle as they continue to look for more yield and a more diverse portfolio, it blends nicely into that below investment grade range. But in this yield environment, I think people are turning over every stone looking for every basis point of return they can get.

Stewart:

The investment shops at these various insurance companies are smart money shops. They're sophisticated. They come to you and you're explaining your views of an asset class. At what level are you starting that conversation? In other words, what questions are you getting from your clients and from prospective clients?

Christopher:

Look, we're all credit geeks so I think the first question is always focused around principal preservation, how you protect your principal and your philosophy around diligence. It’s talking about default rates and how that compares to the liquid market, talking about recovery rates and how that compares to the liquid market. Whether it's senior, junior, what's the yield pickup for where you sit in the capital structure? And then more fully understanding, where in the economy you're investing, whether it's lower middle market, middle market or upper middle market. And so we spend a lot of time talking through different parts of the capital structure and how we focus on principal preservation.

Christopher:

I think on the private side as well, one of the big differentiation points is origination. We spend a lot of time talking through how we originate, what differentiates us from other originating sources and what our relationships look like. And so I think that's something that really means a lot and we spend a lot of time on.

Christopher:

And then I guess what I would say the last part then is really, what's the value add post investment? Our job on the private side is, we're not investing to trade, we're investing to hold. And so our job's not done when we make the investment. It's how involved are we with the company? Do we control tranches? Do we have a required lender status? Are we an agent? It's those types of questions and where we're adding value post investment. It does translate into lower defaults and high recoveries, which ultimately generates the yield premium that we're talking about. But I would say those are kind of the three to four main focus areas that we spend a lot of time on with investors.

Stewart:

I think it's interesting. I think it would be hard to argue that size doesn't help you in this market. Deal flow and origination for sure. What's the biggest misconception about this asset class that you would like to address?

John:

I would say on the below investment grade side – and I spend more time on senior in the early days of investors coming into the space – as Chris said, it was a very heavy focus on “how can I get hurt? I need to preserve capital. I hear you on the yield premium. Everybody wants a yield premium, but at the end of the day, I need to pay my retirees or generate an adequate return to cover my annuity payments”, et cetera. No one wants to lose principal. And I think the early days of private credit on the senior side twenty years ago and on the mezzanine side, probably thirty years ago plus, and Crescent was one of the early players in private mezzanine. The statistics are now there and investors can see the default rates, the recovery rates, the premium returns and it just takes a certain amount of time for investors to get up the curve, get comfortable, dip their toe into the water, whether it's in a commingled fund, if they're larger and have some experience, then they may move to a separate account of size.

John:

And then, Chris and I work together, for example, a lot on constructing a solution to get to a targeted return. We will mix different asset classes. I will consider putting leverage on a vehicle. What is the target return? What is the risk profile? Okay. We can create that product for you. In the early days, there's an education phase, as investors get up the curve, large, small insurance codes, et cetera, they become more sophisticated in the asset class. And then they hone in on, how can I continue to generate higher returns and manage risk appropriately?

Stewart:

Yeah. And they're effectively riding on the benefits of your size. Particularly smaller insurance companies that it's just really about getting access to the asset class and getting access to the deal flow.

John:

That's right.

Stewart:

Okay. That's been a great discussion about private credit across the credit spectrum. And clearly you guys are leaders in this space, you know this space and I think there's a lot more to learn here, but there's clearly value. But I want to turn my last question – I always ask the same question. People are like, “oh brother.” Here's my question. And I'm going to pick on Chris. Okay, so Chris, you come out of undergraduate school, so here we are. It's COVID-19, I teach as an adjunct and I have students that are wigged out about career opportunities and “what should I do?” And on and on and on.

Stewart:

I had a young man email me today about career choice. You're walking across the stage in your cap and gown. And by the way, you're looking good that day. Not that you had a big party the night before at all. And the president of the college sticks out their hand and shakes your hand, hands you your diploma, you walk across, you're all stoked, you go down, you walk down the stairs, at the bottom of the stairs you meet Chris Wright today. What do you tell your twenty one year old self?

Christopher:

That's an interesting question. I think, when I was twenty one, the world was a lot different, but certainly, the opportunities that exist today for career advancement and for defining success are immense. As I look at it and I look back and what we always talk to our people about is, "Put your head down. The early years are going to be a lot of hard work, put your head down, persevere and learn all that you can. And as you're in that process of learning, you're going to find out what really excites you and then pursue that with an incredible passion."

Stewart:

That is good advice. We'll leave it there. I just want to say thank you very much. Andy Kleeman, SLC Management, Chris Wright, Crescent Capital, John Bowman, Crescent Capital. Thanks very much for being on, guys.

John:

Thank you.

Christopher:

Great. Thanks Stewart.

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