Episode Transcript
[00:00:00] Speaker A: So it's predominantly a US market today, although there are lots of conversations about going global and particularly in Europe, and largely because so much of this has been driven by US insurance companies. Part of this, I think, is a view that there's relative value in Europe because it's a little less, well, trodden than the markets in the us.
[00:00:21] Speaker B: Welcome to the Institutional Edge, a weekly podcast in partnership with Pensions Investments. I'm your host, Angelo Calvello. In each 30 minute episode I interview asset owners, the investment professionals deploying capital, who share insights on carefully curated topics. Occasionally we feature brilliant minds from outside of our industry, driving the conversation forward. No fluff, no vendor pitches, no disguise marketing. Our goal is to challenge conventional thinking, elevate the conversation and help you make smarter investment decisions, but always with a little edginess along the way.
Welcome to another episode in our Private Market series in which allocators and thought leaders share investment strategies, case studies and approaches to the current challenges in private markets. Today's topic is beyond how insurers are reshaping private credit and my guest today is Leo Zwoboda. Leo is the perfect allocator to discuss this topic. Leo is the head of Enterprise Portfolio Management at Nationwide Investments. Leo leads a team that is responsible for nationwide investments, asset allocation decisions and top down investment strategy. Previously, Leo was the head of Liquid Alternatives where he focused on hedge funds, emerging market credit and equities. Leo joined nationwide investments in August 2017 from Penso Advisors, a global macro hedge fund. Prior to Penso, he led the liquid ALTS group at UPS Group Trust. And this is where I first met Leo. Well, probably over a decade ago. Leo has been a regular resource for me. I go to him when I'm doing research, when I'm thinking about a new article. He's a great foil. And on a personal note, I'll say he is the first person that I pitched the idea of Rosetta analytics to, the AI based hedge fund I started with Julia Bonafetti. Leo, it is great to have you on the show.
[00:02:17] Speaker A: Great to see you Angelo. Thank you for having me Leo, as always.
[00:02:20] Speaker B: I did my research on the topic. The Chicago Fed reported that private credit has expanded rapidly over the past decade reaching over 2 trillion in 2024. I've seen predictions that private credit could reach 3.5 trillion by 2028. And interestingly ANI, much of this growth is being led by insurance companies. For example, I saw a Bloomberg report that said 58 trillion percent of insurers plan to boost their allocations to private credit. This year and Moody's, this one kind of caught my attention big time. Moody's reports that as much as a third of the $6 trillion worth of cash and investment assets held by U.S. life insurance companies was allocated to various types of private credit investments at the end of 2024. So Leo, tell me what's driving insurance companies interest in private debt?
[00:03:13] Speaker A: So I am obligated at the outset of this to inform your listeners that anything that I say is purely my opinion and not necessarily the opinion of Nationwide writ large. And also to say that, you know, I'm certainly not the expert at a granular level about these spaces. At Nationwide Investments we have a team of about 250 front office professionals working across all asset classes.
And while I have the privilege of working with them and picking their brains to help inform my comments about these topics, they have a great deal more expertise and deeper experience in, in these different spaces. But to talk about it sort of high level from an insurance company perspective, or at least how I think about it. Well, for one, private credit for us means a lot of different things. So certainly I, I think most of your listeners are going to think about private credit in the sense of below investment grade, upper middle market, direct lending, special situations, the type of things that a group like Oaktree is really well known for. But for us we've expanded and thought about private credit and private assets really across the entire spectrum of credit quality. So that includes, you know, private investment grade corporate lending. This certainly includes the private upper middle market, direct lending and special situations, that sort of stuff. But then also there's been a big push over the last few years in particular into private asset backed finance, which takes sort of the traditional things that we think about as getting securitized in the public or liquid structured products market and does it on a bespoke basis. And a lot of that production over the last four or five years has really been consumed by insurance companies.
The principal reason that insurance companies have been focused on this space is the fact that there is a liquidity or some sort of private market premium that groups perceive to pick up in this space, whether it's a function of illiquidity, which we talked about, you know, talked about a little bit before, whether it's the fact that there's certainty of execution around this space, whether it's the fact that there's deal complexity around this space, there's a premium that exists in the markets for being in private assets and particularly on the life insurance in the life insurance business, where if you think about how annuities work in a broad sense. You promise a stream of payments at a certain rate to your annuitants. And the way that the company ultimately makes money is by investing the premium that's paid against those annuities to earn a return that exceeds that promised premium. And then effectively not unlike a bank, we're focused on sort of clipping a spread between the promised rate to the annuitants and what we're able to invest the asset portfolio at. And it's a super competitive market, prices on sort of at least a weekly basis. So being able to access assets that have a spread pickup beyond what you're able to pick up in the public markets is really valuable from a competitive standpoint for life insurers.
[00:06:16] Speaker B: Okay, so you've talked about what I'll summarize is a yield premium and spread enhancement.
[00:06:21] Speaker A: Yes.
[00:06:21] Speaker B: And then you, you've kind of hinted on the life side about liability matching.
[00:06:26] Speaker A: Yep.
[00:06:26] Speaker B: How about on the regulatory side? Any benefits there?
[00:06:29] Speaker A: I would say the biggest benefit that's happened has been the advent of rated feeder technology for particularly below investment grade lending. And that's been a huge advantage because insurance companies are regulated entities. So we take capital charges against all the assets that we purchase.
And what has happened again over the last decade is really where it's become more prevalent is private debt managers will create feeders that are dedicated for insurance companies into their funds and will effectively tranch those feeders like a clo. So you'll get a feeder that has a certain percentage of it as investment grade rated notes, some sort of mezzanine double B piece and then an equity tranche. Each of those pieces has its own capital charge. And the capital charges aren't really linear. They look sort of, you know, they look sort of exponential as you move down the risk curve. So if you had invested in that feeder without any sort of look through treatment, maybe you'd have a 30% capital charge on that exposure. But if you're able to take it in, a rated structure plus weighted average capital charge ends up driving these assets to look more like maybe a single B piece of paper or double B piece of paper, potentially even better.
And that allows you to get better capital efficiency on these assets where we expect to see a yield pick up on.
[00:07:56] Speaker B: Tell me more about. And again, we're talking at a high level, we're not talking nationwide here, this is macro. But tell me more about how insurance companies access these opportunities.
[00:08:08] Speaker A: So it really depends on what your internal capabilities are as well as how capital constrained you Are So groups access this through a number of different ways. Lots of team, lots of groups, particularly a number of the private equity backed insurance companies have teams that are able to originate assets on their own behalf. Lots of groups have large trading teams that are out there working in the markets where syndication is prevalent and they're able to source assets that way. Many groups work with large asset managers. You've seen a lot of that in the news over the last year or so of large insurance companies partnering with asset managers in order to source opportunities. Those are likely to be in some sort of separately managed account, an sma. And then the other prevalent way is through again these rated feeders where asset managers go out and get the feeder rated, they structure it in a way where regulators will be comfortable with the amount of leverage and the subordination embedded in the different tranches. Those are really the most prevalent ways that insurance companies are accessing it. Certainly you know, we also invest in groups also invest in regular way funds where they think that there's an appropriate return on capital for that particular strategy. But for most of the again, upper middle market direct lending, investment grade private asset backed investment grade corporate lending, Those come through SMAs, direct origination or direct purchase or some sort of rated feeder.
[00:09:31] Speaker B: In these various structures. I assume that they're designed to meet your investor specific capital charts issues, accounting issues, tax issues. Yes, it's like a tutorial for me. I've always been a public markets guy, as you could tell by my introduction.
Tell me more about the opportunity set itself. I mean, you know, you mentioned a little bit in your opening comments about you know, what you and your colleagues are looking at. But I've come to see this is a, this is a, it's a big tent I think is one way to say it. It's an asset class.
[00:10:10] Speaker A: Yeah.
[00:10:11] Speaker B: What is the opportunity set for insurance companies specifically in private credit?
[00:10:15] Speaker A: It really runs the gamut if you think about sort of how this market evolved.
It was largely a below investment grade market that was either focused on complex transactions or some sort of sponsor backed financing. And then there's also, there's always been an IG private placement market that is, you know, groups that are looking for maybe a smaller club of investors rather than having to go through a full on syndication process and or they're not raising issues that are large enough to be worth sell side institutions time to sort of market and issue a bond or help them issue a bond. But what's really happened over the last few years is I would say for one, since the gfc. There's been this process of bank dis remediation and that's driven a lot of growth of this market. Not just in terms of the size of the market but also in terms of the breadth of what the opportunity set is. So particularly I think the asset backed finance market has really been, its growth has really been supported by this trend in bank dismediation where you have, instead of having one institution or a handful of institutions that will provide financing solutions for all the different things that various companies might be interested in financing, there's a much larger network of non bank originators and they sort of leverage this private asset backed finance market in order to sustain their business. So they'll originate a bunch of aircraft leases or rail car loans or music royalty streams and they'll securitize those cash flows in some sort of private, private structure. So when we, I think when insurers think about this market again, it ranges all the way from, you know, large public issuers that are issuing in sort of a bespoke fashion, all the way down to sort of sponsored backed below investment grade issuers and then a large array of different sorts of consumer financing, corporate financing, corporate lending that ends up getting securitized into the asset backed market.
[00:12:23] Speaker B: It seems given the breadth of the opportunity set. You know, two things come to mind. One is, you know, I'll mention nationwide for a second here because you talked about the size of your team and I now have a better understanding of why you need a sizable team to properly explore this, you know, this market because you've already talked about research trading, we bring in tax, we bring in accounting, et cetera. And the other piece that comes to mind, Leo, is there's got to be a benefit of portfolio diversification for you.
[00:12:55] Speaker A: Yeah, absolutely. And particularly on the private asset backed side because you have many more different types of collateral. Credit's really just equity in sheep's clothing.
So you know, you have that risk in the portfolio when you're long a bunch of corporate credits. And if you're able to diversify across a number of collateral types, if you're able to end up sort of having some secured, some security or subordination that you're able to structure through either the way that you're able to the covenants that you have or the way that you've structured the securities, you're able to diversify not just across the, the different types of collateral risks or the different type of lending risks, but also you're able to diversify across the different sort of structure risks and where you are in the capital stack across these different opportunities.
[00:13:39] Speaker B: In general, given what we're seeing in the industry, an increase in allocation to private debt, does that mean a decrease in exposure to other fixed income assets, perhaps committing less to high grade corporate bonds?
[00:13:54] Speaker A: I think at the margin you'll see some of that. I think you're also seeing it in issuance numbers. Some of the things that we look at on a regular basis are the volume of issuance. And we look at it more from a macro risk factor.
I think gross issuance growth in the US and corporate credit this year is about 2%.
So that's a relatively low number relative to history. And I think some of it is people looking for sources of financing in other channels. I think the other thing that's happening though, as this market is growing, it's becoming less of a niche. So whereas again, early in the, in the life cycle of this product space or opportunity set, the yield premiums were really pretty significant, especially if you were to think about like upper middle market direct lending versus bsl. And it has a lot of similar characteristics to the syndicated loan market in that it tends to be below investment grade issuers, they tend to be smaller or newer issuers, and the loans tend to be floating rate. The spreads on that market on a gross basis relative to private credit, particularly after you adjust for fees for some of the managers have really compressed pretty significantly. And now you're starting to see sponsor backed companies actually refinance in the BSL market instead of sort of staying in the private credit market. So we're moving to a place where what people have thought of for a long time as being this sort of new and niche opportunity set is really just another tool in the toolbox for companies to access the financing that they need. And I think that my view is that the net impact of that is that spreads sort of compress and kind of normalize across the entire spectrum rather than continue to offer a very wide premium for private markets.
[00:15:40] Speaker B: You mentioned something in your first comment there. It takes us, I think, to a discussion of the risks. It's wonderful. You've got yield, you've got regulatory benefits, you got diversification spread, but there are risks embedded in this at a high level. Again, what are the key risks and how would a, for example, an insurance company manage those risks?
[00:16:02] Speaker A: I think the principal risk is illiquidity. So none of these assets that we're purchasing have a ready secondary market.
So in the event that there was a need to raise capital or raise cash you'd want to make sure that you had other assets in your portfolio that you were able to offer into the market in order to do that before you had to tap into these, these private securities. Otherwise, you know, it's a lot of the same risk that you would have in credit markets writ large. So you're concerned about, you know, the quality of the company that you're underwriting, you're concerned about the quality of collateral, you're concerned about the covenants that you have.
I do think one thing that people talk about a lot in the private credit market, particularly in below investment grade market, is the ability of the managers who manage those pools of capital to, for lack of a better word, sort of obfuscate credit problems.
So you've seen an increased incident in pick for those types of in the private credit market, whereas in the BSL market that maybe might have moved sort of immediately to an event of default. There's the ability of the managers to get ahead of that either by renegotiating terms, accepting pick if a company has difficulty making coupon payments.
And I do think that is a risk in that as an investor, you may not, you may have to sort of go a level deeper in your conversations with the manager in order to really understand how the positions in your portfolio are evolving over time. Because you don't have the same level of transparency that you might have for something that's broadly syndicated.
[00:17:39] Speaker B: Could you structure certain covenant protections and control rights in the negotiations so you have some downside protection?
[00:17:48] Speaker A: I suppose you could. It's not something that I'm aware of, sort of being very prevalent in the marketplace. Again, I think the hope is that you've picked really good partners who sort of retain the integrity of their underwriting sort of throughout the economic cycle and don't get sucked into some of the particularly kind of easy money games that have happened over the last couple years. You've talked about, people talk about in the BSL market where you're seeing renewed prevalence of cov light loans, worse credit quality without necessarily seeing a comparable increase in spread pickup.
So the hope is that the partners that you're working with are advocating for you as an investor and able to structure deals that provide an adequate level of protection for the rest that they're taking.
[00:18:31] Speaker B: Going back to the opportunity set is this global.
[00:18:35] Speaker A: So it's predominantly a US Market today, although there are lots of conversations about going global and particularly in Europe.
So Europe has historically had a much less developed sort of public finance market. It's always been a very Heavily banked market relative to having a great deal of investor interest. That trend started shifting after the global financial crisis and it's picking up even more today and especially on again this private asset backed finance piece of the market where there are more opportunities becoming available in Europe and largely because so much of this has been driven by US insurance companies.
Part of this I think is a view that there's relative value in Europe because it's sort of a little, well, less well trodden than the markets in.
[00:19:23] Speaker B: The US and the banks may have a stronger hold on the market and they're not up for the disintermediation perhaps. I don't know.
[00:19:30] Speaker A: Yeah, but I mean those banks continue to be very heavily regulated, so they have had to cut back on some of the lending that they might have been able to provide previously. So I think you're seeing an increased interest in companies engaging with private credit managers to solve particularly complex financing needs that maybe a bank would have solved five or 10 years ago and now for regulatory reasons, may be unwilling to wade into that territory.
[00:19:59] Speaker B: What haven't we talked about in this space, Leo? I mean, what do you and your colleagues talk about again at a high level?
We've talked about benefits, we've talked about risk, we've talked about structures, we've about talked, we've talked about opportunities set. What am I missing here?
[00:20:13] Speaker A: I think one thing that you sent over in your pre show notes that we talk about it is how do we think about benchmarking this space?
And I think there's lots of different ways to think about it. Philosophically, if you're capable of purely integrating your public and private functions across kind of a structured product lens, a below investment grade lens and an IG lens, then I think you can probably get away with using public benchmarks and thinking about your private allocations as off benchmark bets relative to the public. The problem is when it gets really large, is that really a fair comparison anymore, particularly for below investment grade? And when you're talking about the upper middle market, direct lending, I have not yet seen benchmarks. I mean it's the problem that we have with all private assets. Right. You have the same problem with hedge funds, you have the same problem with private equity. Getting benchmarks that provide an appropriate level of detail that you can really understand what the universe is and what are the risks that you're sort of taking in your portfolio relative to that, that opportunity set. So I think benchmarking continues to be a problem across the space. So because you have a much broader set of collateral types in the private asset backed finance space than may be represented, maybe represented in like a CLO index or an ABS index. It's an open question about how you would think about kind of benchmarking that opportunity set versus some kind of publicly traded index.
[00:21:39] Speaker B: So how do you solve for that? Is that an internal discussion that, that you know with your risk group or.
[00:21:44] Speaker A: It'S an internal discussion with, with your risk group and with leadership? I think it, it advocates for a conversation about being goals focused rather than necessarily benchmark focused. How are the decisions that you're making from an allocation perspective supporting the broader organizations of the enterprise rather than just. It's kind of beating a benchmark that might have been picked in some kind of saa. But it's an ongoing conversation and I think it's one that we and our peers wrestle with.
[00:22:14] Speaker B: So we've talked about the benefits, we've talked about the risks. We're seeing more and more non insurance companies enter this market. Do you think that insurance companies have a competitive advantage as investors in private credit?
[00:22:29] Speaker A: To the extent that insurance companies may have larger asset bases and or larger teams support the efforts, possibly. But all allocators are competing at some level for the same objectives for their portfolios. And people will move to where they see the best relative value for the risks that they're willing to take to earn whatever return it is that they're trying to achieve. So if a large state plan wants to move significantly into this space because for them it's an appropriate risk relative to their portfolio, I don't know that they have an advantage for us. I think that that just ends up relative to us. I think it just ends up hastening this kind of broader spread compression theme that I was talking about earlier.
[00:23:12] Speaker B: I mean, what I was thinking is that, you know, at the beginning of your remarks you talked about specialized team, you got sector expertise. I mean this kind of fits in the entire worldview of insurance companies where you're looking for that yield enhancement spread.
And you also have, at least in the back of my mind, insurance companies have been doing credit analysis basically for generations.
It's not something that would be new where I'm sure we could talk about a public plan and they may have some expertise in that staff, but it may not, they may not have the bench or the experience that an insurance company may have.
[00:23:53] Speaker A: Fair enough. So I think that insurance companies are required or challenged by the competitive dynamic of the market to be willing to be a first mover in spaces like this, in a way that maybe some other allocators aren't necessarily required to do it, but also the fact that we tend to be as a group, much more yield focused and yield sensitive. This is a place that we want to focus on and we'll have more capital against than, you know, a public equity allocation or even a private equity allocation. Because for the types of liabilities that insurance companies write, products like this that have current coupon, have yields that we can very clearly show to regulators, support the types of products that we're underwriting, they're going to be highly in demand for insurance companies and they'll check boxes for insurance companies that other types of allocators may not have. Right?
[00:24:52] Speaker B: Yeah, yeah. Especially on that, you know, the.
I'll call it the capital adequacy. You know, your requirements.
[00:24:59] Speaker A: Yeah, absolutely.
[00:25:00] Speaker B: That's huge for you, especially with the structuring you've discussed. Well, Leo, I think we've hit our 30 minute mark.
We'll have to find out in the editing process if we actually made it that far.
So let me say thank you and ask you to wrap this up and tell me what I ask all my guests. And I know you're going to twist this on me because you always do.
What's the kind of the worst or the wackiest investment pitch you ever heard?
[00:25:26] Speaker A: I can't think of a pitch that stands out that was particularly bad. All bad pitches are bad in their own way, but I've not heard anything that was so sort of patently absurd or ridiculous, at least on the institutional side. I can tell you about kind of the worst breakup call that I ever had. I mean, I think we've all.
Anybody who's been in this business for a long period of time knows that, you know, sometimes you've got to walk away from a relationship. And, you know, the vast majority of the people that I've had to do that with, they've been very cordial and very professional. I sort of joke that there's no. Or tell people who are new to this business that there's no point in being a jerk because the person that you were a jerk to is just going to end up at another shop. And if you need that shop's help as a partner or you're looking for a new opportunity, you don't want to have the reputation for having been a jerk to that person. But in early on in my career, we were invested with a hedge fund that engaged in a little bit of a strategy shift relative to our underwriting.
And I we'd Sort of let them go with it a little bit. We wanted to see how it played out.
They had a much larger equity allocation than we had expected them to have through underwriting.
And one of the things that we really focused on in our hedge fund allocation was convexity in the return profile.
So by putting all these equities in the portfolio, they embedded a great deal of equity beta, and the equity markets sold off, particularly in the sectors that they were invested in. And we really didn't feel like that was what we had signed up for with this manager. So I called the client service person and I said, look, I just, as a courtesy, I want you to know that we're going to be submitting a redemption request. Here's our reasoning. We don't really feel like there's as much convexity in the portfolio. There's a lot more equity exposure than we thought that there should be. And the client, our relationship manager's response was, well, I mean, these equities have gone down so much. There's way more embedded convexity in the portfolio. And I said, I didn't feel like that was a very compelling response.
And they said, okay, well, that's great, but I think the founder is going to want to have to have a conversation with you before we accept the redemption request. So I said, okay, fine. So I get back to the office, I talk to my boss, who you know very well, and I say, hey, like, the founder is going to call me. I want you to be on the call. I want you to hear what's going on. Because I was, I mean, I was maybe 25 at the time. Like, I just started doing this.
So, you know, we get in the conference room, get on this bridge line with the, with the founder, and so I understand you're submitting a redemption request. And I say, yep. And I walk him through our, our rationale. He provides the same response. Well, you know, well, look, I mean, and it's basically like, well, if we, if you, if you liked it at 30 going to 60, you're going to love it at 15 going to 60.
Again, like, I don't feel like that's. It's not really what we signed up for. And I said, well, I appreciate that perspective. You know, I don't really feel like that's sort of convexity to one portfolio. And he said, okay, goodbye, and just hung up the phone on us right there.
So that was, you know, luckily my boss was there, both my bosses were there, and they heard it. And, you know, I don't, you know, they didn't seem to think that I had handled the situation inappropriately at all. But that was. I chopped that up as one of my. One of my weirdest breakup calls with a relationship that we had.
[00:28:41] Speaker B: It sounds like it. I have to tell you. I mean, and I appreciate you taking the extra step to talk to the founder because you could have said, no, no, I'm done. I really don't need to justify this. We're the client.
[00:28:53] Speaker A: One of the things that I like about this is that at every level, until the robots take over, this is a people business. And I've had the great fortune of working for and with some really excellent people and making some really great friends, yourself included in the time I've been doing this. So no point in trying to sort of out muscle or be a jerk to anybody. I don't see any upside in that.
[00:29:15] Speaker B: I agree. It's a short street. I always tell people.
[00:29:18] Speaker A: Yeah, for sure.
[00:29:19] Speaker B: Well, Leo, thanks. This was great. I appreciate the tutorial. I appreciate you weathering the technological storm we may have experienced, but here we are.
[00:29:28] Speaker A: It was my pleasure, Angelo. Thank you so much for having me.
[00:29:30] Speaker B: Thanks for listening. Be sure to visit PNI's website for outstanding content and to hear previous episodes of the show. You can also find us on PNI's YouTube channel. Channel links are in the show Notes. If you have any questions or comments on the episode, or have suggestions for future topics and guests, we'd love to hear from you. My contact information is also in the show notes, and if you haven't already done so, we'd really appreciate an honest review on itunes. These reviews help us make sure we're delivering the content you need to be successful. To hear more in the insightful interviews with allocators, be sure to subscribe to the show on the podcast app of your choice. Finally, a special thanks to the Northrup family for providing us with music from the Super Trio. We'll see you next time. Namaste.
[00:30:23] Speaker A: The information presented in this podcast is for educational and informational purposes only. The host, yes, and their affiliated organizations are not providing investment, legal, tax or financial advice. All opinions express expressed by the host and guest are solely their own and should not be construed as investment recommendations or advice. Investment strategies discussed may not be suitable for all investors as individual circumstances vary.
