Episode 31 | The intersection of private credit and insurance company capital

CJ Doherty Welcome to the Lending Lowdown. I'm CJ Doherty, director of analysis at LSEG, LPC. In today's podcast, we're going to talk about the intersection of private credit and insurance company capital, including a look at structures and updates on the NAIC’s activity in this area. The trillions of dollars in insurance holdings no doubt represent an opportunity for the private credit industry. Joining me to discuss all this is David Ells, who is Partner and Portfolio Manager at Ares Management , and Ryan Moreno, Partner and Co-head of Leveraged Finance at DLA Piper. Thank you both for joining me. David Ells Thanks, C.J. Ryan Moreno Nice to be here. CJ Doherty So to kick it off, can you both introduce yourselves and give some background on your role? And we can start with you, David. David Ells Thanks, C.J. So I'm David Ellis, partner and portfolio manager, as you said. I focus on private credit investing in Ares with a specific target of asset based finance transactions. Well, at the same time, I also help my, a lot of my insurance companies with their strategic asset allocation. So kind of the big picture. My background is, I spent 15 years at Northwestern Mutual Life, both as a portfolio manager in these areas, as well as in management as the head of strategic asset allocation for the company. And prior to that, I worked at, Guggenheim and its predecessor company, Liberty Hampshire. Ryan Moreno Ryan Marino, Co-head of Leveraged Finance at DLA Piper. We represent banks, non-bank lenders, like private credit funds, insurance companies, pension funds and a variety of financing transactions. I, in particular focus on private credit and front finance personally. CJ Doherty Great. So let's start at a basic level now. And David, can you give an overview of the role played by insurance company capital in private credit? How prominent is it and to what extent have allocations increased over time? David Ells Sure. So if we look back, over time and I'm going to define private credit the way you guys did in a podcast that you did a few weeks ago, you defined it as non-bank lending effectively taking place in this area. We're going to leave out corporate bonds and other things that are syndicated and really focus on those that are more directly originated. And in some ways, Insurance Capital was the original private investor. They've been doing private placements for decades. They've been doing commercial real estate lending for decades. The evolution that's really taken place is when the early 2000, when the BDCs came about and they started doing lending with capital outside of the bank channels. So originally they were buying things from banks, but then they started saying, well, we can originate this stuff ourselves and started doing it that way. That led to some involvement with insurance, but not a lot, because of course, that's predominantly a non-investment grade product or in many cases even a non rated product. So the evolution of an intersection with insurance capital really didn't happen until after the GFC, when we started doing more structured type securities and you started having investment grade ratings, and therefore the insurance companies could participate in meaningful ways. Because of course, an insurance company balance sheet is about 80% IG-rated bonds. And so that started out in more simple transactions. You know, this is an evolution that comes out of, residential and commercial real estate securitizations and things like that. But now it's moved into doing all kinds of different transactions in which we can create capital structures and create investment grade bonds. As far as allocations go to this space, I think what you've seen is that as the private equity industry has really become part of the insurance industry, now, you've seen the allocations to these kind of things go up significantly. So I've seen people that have allocations to broadly private credit. But, you know, that's really with the caveat that we're talking IG private credit. I've seen allocations as high as 40% in some insurance companies. And then you see a little bit of a bifurcation where you're having the more traditional and smaller insurance companies get pulled along, and maybe they're in the mid-single digits coming into the high single digits now, but their allocations are significantly lower. Ryan Moreno Yeah, I would just say on top of that, I mean, now there is a specific allocation for private credit for insurance company investors, whereas like ten years ago, let's say that wasn't even necessarily on their radar. So now I think that's in large part of why we've seen kind of an explosion in interest from insurance companies in those products. CJ Doherty Okay, great. And so let's build on that a little bit. And next question is to what extent do insurers have complex needs compared to other institutional investors? Are there specific requirements or demands that insurance capital asks for in order for them to invest? You know, what do they look for? David Ells Yeah, there's several things here C.J. that that go into insurance investing. Of course, the first thing about being an insurance company is that everything is viewed through a lens of capital. You have to allocate capital against everything that you own. And so you're always trying to optimize that capital in what you're doing. And the way that the majority of things on an insurance company balance sheet get allocated capital is through the ratings process. So virtually everything that gets done in this space that's going into an insurance company has to have a rating attached to it. And so the other aspect to this that's so important for insurance companies is that they have duration in their liabilities. And so because they have that duration and it's long, they tend to invest in fixed rate instruments very different than the BDC market and the bank lending market, which is predominantly a floating rate product. And so a lot of the assets that are being created are being created specifically for insurance and intended to have duration and are fixed rate. Ryan Moreno And the other thing really driving this are the risk based capital requirements that are put on insurance companies by their regulators. RBC requirements are essentially the statutory minimum level of capital insurers are required to maintain, you know, to essentially avoid regulators getting involved with their business. And that's really based on two primary factors. Number one, the actual size of the insurance company and its balance sheet. And two the inherent riskiness of its financial assets and operations and investments. And so, you know, what happens is every investment the insurance company makes is essentially given an RBC charge that's applied to it. And so that asset value gets risk adjusted and effectively discounted with the particular RBC charge applied to that investment. So the RBC charge that goes into all these investments is something that insurance companies pay a lot of attention to. And a lot of, you know, ingenuity and structuring have gone into these products to essentially achieve the most efficient RBC charge possible for the insurance company investor. CJ Doherty Okay, great. Some some good color there. And when it comes to insurance capital and private credit, can you describe the different structures you are seeing? How do they work? David Ells So this is really Ryan's area of expertise is creating these things and documenting them and all that. But if you think about most of what we're doing in private credit inside of insurance companies, we're generally forming some type of a pooled holding vehicle. And so therefore we're creating probably a trust in most cases designed to hold assets, designed to hold loans, designed to hold a portfolio of these investments. And then we can take that and we can turn around and get that rated. You know, it can take a variety of forms and the ingenuity that's taken place in this space continues to evolve. But that's the predominant way that you see these assets held on the balance sheet. Ryan Moreno Yeah, I view it through a lens of there are off balance sheet options and on balance sheet options, an on balance sheet option for an insurance company would be entering into an SMA with an asset manager, where they essentially enter into an investment management agreement with the asset manager. And the asset manager goes out and sources investments for the insurance company, sometimes on a discretionary basis, where the insurance company gets to say yes or no to certain investments, sometimes on non-discretionary basis, where there's eligibility criteria that's negotiated upfront and concentration limits and things like that, that give the insurance company investor comfort that the products that ultimately owns, you know, fits the box that it wants to fit in, but gives the asset manager a bit more flexibility to go out there and source those. So that's the on balance sheet option, where at the end of the day, the actual insurance company is holding the particular middle market loan asset, whatever it is on its balance sheet, directly. The kind of off balance sheet options I would think about are rated feeder structures. So this is a very popular one where if you take a private equity fund or leveraged buyout fund, whatever it is, we'll talk a little bit later about in terms of, you know, if the NAIC is fine with these products on top of LBO funds and private equity funds, but let's say let's let's take a credit fund as an example. A typical private credit fund is set up as a limited partnership. Right? Or an LLC whatever. But it ultimately is issuing equity interests out to its various investors that participate, you know, through the fund and directly with it, with their equity. That in of itself is essentially the worst form of RBC charge you could get from the insurance company investor because the, the insurance statutory accounting principles will say that's just an LP interest, which is essentially a common equity, interest and it's really just equity upside if you think about it. So what smart people have done is they've created what's called this rated feeder, fund structure, where you have a rated feeder fund that sits on top of the main credit fund, and the rated feeder fund issues tranches of senior debt that gets rated typically an investment grade rating. And then sometimes it kind of depends on the asset manager you're working with. And the sponsor, they'll be a mess level. And then there'll be, essentially an income notes level or an equity level. And the insurance company will essentially participate through the fund by buying a vertical strip of those notes and equity interests. Sometimes people have gotten more creative recently by allowing investors to buy what we call a horizontal strip, so they can either participate in just the senior or just the income notes, depending on the type of investor and their, appetite for risk. But ultimately, this structure gives a better blended RBC charge for the investment for the insurance company going into the private credit fund than it would otherwise received if it were just going directly into the fund as an ordinary way investor, just like everyone else. So that's just one of them. There are CFO structures as well, which kind of act similar to a rated feeder, except I would say one of the main differences is that at the very bottom, it's a commingled portfolio of a bunch of different fund interests, rather than just going into a single fund strategy. But there's a bunch of interesting ways that people are kind of getting creative about this. CJ Doherty And what are the benefits to insurers of these types of vehicles? Is it mainly lower capital charges? David Ells I would say this C.J., the idea here is to optimize capital charges and to make it commensurate with risk. Right? There's an efficiency that comes from doing things on a pooled basis. You know, if I'm an insurance company and I go out and I make, you know, 100 or 1000 or 5000 loans in a particular area, right. And any one of those things has a risk of default that's contained in that RBC charge. If I hold those at the balance sheet, you know, without any structure around it, you know, I've got a certain level of risk, but it's generally fairly punitive for the insurance company and not not capital of, efficient for them to make those kind of loans. If I pull those things into a structure, you know, the risk of the entire portfolio defaulting at the same time is effectively negligible, right? It's you got the law of large numbers, you've got diversity, you've got all those kind of things. And so a certain amount of that portfolio then becomes IG and becomes very ratable. And you still can hold a residual position in the pool if you want to hold the entire pool. But it's really to create an efficiency that comes from the insurance company being able to hold things in that manner and hold proper amounts of capital, but not hold excess capital against a portfolio like that. CJ Doherty Great. And let's now talk about the regulatory side. And maybe if we could start with you, Ryan, could you give us an update on NAIC activity in this area? Is there any impact on allocations? Ryan Moreno Sure. So so just to level set that NAIC right is the the national US regulator for insurance companies, and they essentially act in tandem with the state insurance regulators to, you know, put out, you know, rules and, regulations and, and kind of how that's all supposed to work. And ultimately, you know, what the NAIC in the state the insurance regulators are concerned about is, solvency and making sure that we have healthy insurance companies that can stand up and pay off their policies at the end of the day. So I would say there's a couple of different areas where the NAIC has had focus in recent years. Number one is, you know, private equity ownership of insurance companies and which is obviously, you know, has become, you know, a big thing like every big asset manager out there, right? You know, Ares has Aspida, Apollo has Athene. They're all kind of working together and tapping those sources of capital. And the NAIC is definitely interested in what's happening in this front there. You know, there's questions about affiliation issues and how people are disclosing that and in terms of disclosing related party transactions. So that's been one area of of high level focus, but that's not really particular to this podcast in this particular discussion. And that's really more about, I would say, the NAIC focus on rated feeders, primarily, I mean CFOs. Ultimately, the regulators didn’t love the rated feeder product at the beginning because they just viewed it as RBC arbitrage at the end of the day. Right. But they've issued guidance recently where they've come out and recently, I would say, meaning the end of last year, where they've come out and basically made it clear that they are okay with rated feeder funds that sit on top of credit funds because ultimately, if you think about it, the risk and the pool of exposure to the insurance company investor at the end of the day is a pool of loans. So they feel more comfortable about that. And ultimately they can get there. A rated feeder fund on top of a private equity fund or leveraged buyout of fund made clear that they're not happy about that kind of structure, because ultimately, you're taking equity risk and repackaging it to a certain extent. And so that's one where I expect to see challenges and some structure is being wound down in the next couple of years. The other kind of main area I've seen, the NAIC come out is with the updates to the bond definition and to their oversight over the SVO process. The bond definition goes along to the rated feeder product, like we just spoke about before. They've issued some updates to the actual definition itself that's meant to essentially attach the rated feeder product on top of LBO funds on the SVO side. So there's a, there's a unit within the NAIC that is essentially tasked to look over the ratings and specifically the private letter ratings that are issued to investments for insurance companies. The level set for the listeners here, there are many types of investments that can get what's called a private letter rating from a rating agency. That effectively gives the insurance company investor, an automatic RBC treatment for that particular investment. So this is something that's made the NAIC kind of want to get a little bit more involved, and to make sure that the SVO has the ability to actually look into these private letter ratings and ultimately get to a place of saying they agree or not agree with the actual rating that's been given and the associated RBC charge that goes along with it. So there's been a lot of upheaval in the industry about that because, you know, there's thousands of issuances a year and people are asking credible questions of how is the SVO actually going to review all these? Ultimately, I think they got to a place of they're going to spot check, you know, issuances here and there. And I think the market has been pretty happy about that versus kind of a consent process on every single issuance. But it's definitely been an active area. And in terms of allocations or less interest in these products, I haven't seen any kind of depth in terms of insurance companies looking to invest through these products because of any of the guidance that the NAIC is putting out. David, I'd be interested if you've heard anything locally on your end about any insurance companies kind of having issues with what the NAIC is saying and not necessarily wanting to do a rated feeder or something else because of that. David Ells Yeah, I think your point, Ryan, is spot on, which is that there are certain structures or certain types of investments that I think the NAIC has either come out explicitly and said, this is a no no area, or they've put out some proposed language and said, this has us concerned. And then they get feedback from lots of different companies and parties that are involved in it, and they they come up with a way of managing that. For instance, as Ryan pointed out on on CFOs and rated note feeders, they they were very adamant that equity investments for some of those types of things are not appropriate, but credit funds are just fine for those kinds of things. So things like that take place with them. At the big picture level, you know, the challenge for the NAIC has been you've got an enormous amount of capital that's flowed into the insurance industry for people who are very sophisticated investors. And the old days of the NAIC coming out, looking at your corporate bond portfolio and your real estate portfolio and saying, giving you a look, see, on whether or not you're you're healthy and solvent, you know, has gotten much, much more challenging for them. This has become a very sophisticated industry in terms of the kinds of investments they're making. And the NAIC is doing a heck of a job trying to keep up with that. But it's very challenging for them because there is a lot of people working on this on the other side. Ryan Moreno And I would also say, I think there's this kind of theme in our industry that the NAIC is allergic to private equity in insurance companies to private equity and insurance companies, and I don't really think that's accurate. I think they're just trying to get their arms around it. And I do think they actually appreciate, you know, what private equity can bring to bear for insurance companies, because I think everyone can agree, like it's not a great thing for a bunch of life insurance companies to hold their investments and, you know, the pennys in the couch cushions, right? Like they should be doing it in a an efficient, smart manner that brings along the best risk adjusted return for the insurance company at the end of the day. So I don't think they're just automatically trying to prevent private equity investment or ownership in the insurance company space. I think they're just, you know, a little bit cautious and want to kind of better understand the different structures people are putting in place. And also definitely the affiliation issues that come up, when you have an asset manager that enters into an IMA with an insurance company that may or may not ever be able to be terminated. And so it kind of raises questions of, are they affiliates or not? CJ Doherty Okay, great. Some some great insight there on the regulatory side. Now just finally, I think it's hard to ignore the news in the last week on the economic policy front. So let's finish up with an outlook question. You know, given the market volatility we've seen in the last week with the introduction of tariffs, what impact will this have on private credit in general and private credit when it comes to insurance company capital? David Ells Yeah it's been an interesting week to say the least C.J. From the point of view of private credit, you know, we're in a hiccup phase I guess, you know. We'll see what happens longer term. Certainely deal activity has slowed down in terms of M&A and things like that. But I have full faith that things are going to rebound. It's a question of the duration of this period that we're in. From the point of view of insurance intersecting with private credit, I don't think there's any doubt that the trend that we've seen is going to continue, and this will look like a blip on that radar screen at some point between the cost of the liabilities has increased, originating the liabilities has increased for these insurance companies. At the same time, you know, the returns available in traditional corporate bonds and things like that have decreased. And so it's very important for them to look for other sources of return. And and I want to key off something Ryan just said. When we look at private credit and the things that we're doing in this space, there's there can be a perception from outside that the insurance companies are taking more risk, more credit risk specifically. And I think that that's a misnomer in the industry, what the insurance companies are really doing is they're looking to take credit risk and add some amount of illiquidity premium to it and structural complexity premium to it in order to achieve a higher return. That's very consistent with traditional credit markets. You know, the private placement ready market trades at a premium to the corporate bond market, right? Because it's not liquid. Same thing here. There's additional asset spread asset yield available in these types of assets from the factors of illiquidity and structural complexity. They're harder to originate. They're harder to get your hands around when you underwrite them. They're harder to rate, all those kind of things. And so the industry is going to keep moving into these assets. I don't have any doubt about that. Ryan Moreno Yeah, I would say the uncertainty of the moment is not great for deal flow today or for like the next month, let's say. But I actually think this is a great macroeconomic environment for private credit right now, where you're going to have a bunch of companies, they're going to have some real distress sooner rather than later. And real interest payments to me like this is not 2020, right? With like a zero rate interest environment, we're going to see some real dislocation and private credit is sitting on some significant capital and dry powder right now. So I think you're going to see a lot of asset managers kind of looking out there and licking their chops. And finding some some great deals in the next coming months. Just right now, today, I think people are just kind of holding off and seeing how everything plays out. And in terms of long term insurance company capital and, and private credit, I think that is just here to stay. I think it's going to continue to grow. And, you know, the I think the one interesting thing is there's a bunch of asset managers out there right now, right? So I think you'll probably see some retrenching in some of the more existing non players in the next year or so. Just because the market's gotten so frothy in terms of fundraising. But ultimately I think it's a a marriage that's here to stay. CJ Doherty Great. And that's all we have time for today. David and Ryan, thank you so much for joining me today. It's been great having you. David Ells Thank you C.J. Ryan Moreno Good to be with you. CJ Doherty And thank you all for tuning in. As always, I invite you to check out our private credit news data and analysis at longconnected.com. I'm CJ Doherty, subscribe to the Lending Lowdown on your favorite podcast platform. ----- When you contribute your fixed income deals to LSEG, they'll reach over half a million buy and sell side professionals around the world and be included in our industry leading league table rankings. To ensure we're capturing your entire deal flow, visit contribute.lseg.com/fisignup or contact our team at [email protected]. Make your deal count.