Can Credit Secondaries Solve the Liquidity Puzzle for Insurance Portfolios?

Stewart: Hey, welcome back to the InsuranceAUM.com podcast. We are the home of the world's smartest money, and I'm Stewart Foley, I'm your host, and we're thrilled to have you with us today. Every major private market eventually develops a secondary market. Private equity did it, real estate did it, and now private credit appears to be reaching that inflection point as well. And for insurance investors in particular, that evolution could have important implications not just for return opportunities, but also for liquidity, portfolio construction, and capital efficiency. Let's not forget capital efficiency. So the title of today's podcast is ‘Can Credit Secondary Solve the Liquidity Puzzle for Insurance Portfolios?’ I'll get it out. I'm joined today by Josh Ufberg, senior managing director at Blue Owl and a member of the alternative credit investment team. Josh leads the team's corporate and opportunistic investment efforts, including capital solutions, fund solutions, and commercial solutions.

Prior to Blue Owl, Josh was a partner at Adelaide Capital Management where he oversaw the firm's corporate and opportunistic investment activities. Earlier in his career, he was part of Goldman Sachs Specialty Situations Group. You got a love special sits, Josh, that's fantastic. You have sat on both public and private markets. We're thrilled to have you today. Thanks for being on the show.

Josh: Thanks for having me, Stewart.

Stewart: So before we going too far, a little background, where'd you grow up? And if you weren't doing this job, what job would you most like to have instead?

Josh: Sure. Well, first of all, thanks for having me. Happy to be here. I'm originally from Pennsylvania. I'm from a small town in Northeast Pennsylvania called Wilkes-Barre, Pennsylvania. If you're familiar with that town. More famous recently because it's proximity to Scranton, which is now indelibly in people's memories for The Office. And if I were not doing this job, I've always been really interested in food and restaurants. That was actually my first job was in working in every capacity of a restaurant, so it'd probably be in some area of restaurants, but I've since learned that this is a business that I prefer.

Stewart: Did you cook? My first was in food service as well.

Josh: Is that right?

Stewart: Yes. I was on the grill at 16 at McDonald's. Absolutely. I have a feeling that your career was loftier than that. You said you did all aspects. Did you cook too or just-

Josh: Yes. I've been on the line. My first job was as a prep cook, which is less glamorous than any of the jobs that we're talking about. You get to literally see how the sausage is made, learn how to make different kinds of food. There's certain foods that I actually will be very careful about ever eating again because I've learned what actually goes, the ingredients that go into it. But yes, that was my first job.

Stewart: Okay. We're not going to go there. That scares me. All right. So, let's start with the big picture. So private credits has exploded over the last decade, but what most people think of as private credit is actually only a fraction of the broader opportunity set. How would you frame the market today?

Josh: You're right. Private credit is still a fast growing market. If you look at the broader landscape today, the private credit universe makes up about $2.3 trillion of assets. People might be very familiar with direct lending, which makes up a significant portion of that $2.3 trillion, but it's not by any means the only component of private credit. So we in the alternative credit business spend the majority of our time in private credit, but in areas that are outside of direct lending. And that includes lots of different flavors of private credit. I think what's important to keep in mind is that the private credit landscape is still growing really fast and the expectation is that that market will double over the next few years and by 2030, it'll be $4.5 trillion dollars.

Stewart: It's interesting. We talked a little bit about this when we were talking preparing for this call or for this podcast, and we talked about the fact that the better the secondary market is supportive of the primary market. But for listeners who may not spend their time in this particular market, can you talk a little bit about, just help us understand what is a credit secondary and why is this market developing so quickly now?

Josh: So a credit secondary is any transaction where an underlying investor, whether it's a GP or an LP is seeking liquidity. They're seeking liquidity because there could be a variety of reasons why they would want to seek liquidity, but they're effectively seeking it before the fund's natural end. And that's the opportunity for us where we can step in as a buyer. I think when you think about every major primary market, it really starts with the primary market and the secondary market is a derivative of that primary market. Each of these primary markets develop this secondary market and it usually is very highly correlated to these markets growth.

So if you look at the private equity market, for instance, the secondaries market has become a significant portion, a much more significant portion of the underlying assets than it is for, say, credit, but capital formation and private equity happened faster than private credit. We're about 10 years behind what the private equity capital formation. Now that that capital formation has really taken off in private credit, it's created this opportunity for secondaries to be a bigger component of the potential options for people to get that liquidity.

Stewart: I know this isn't a topic of this podcast, but how long did it take in private equity to get that secondaries market to be close to what it is today?

Josh: Yeah. I mean, if you look at capital formation, it's about 10 years in front of where private credit is. And if you look at just as a percentage of the overall primary market, private equity today represents something closer to 3% of private equity where private credit is still less than 1%. It gives you an idea directionally of the ability for those private credit assets to become even more commonplace for them to be secondaries. I think it's also worth highlighting that 80 of the top 100 private equity fund managers have now participated in some kind of a secondary. So it gives you an idea of that adoption being very common in private equity, which is obviously highly correlated to the larger percentage of secondaries.

Stewart: Yeah. I think that the development of this market is pretty ... I mean, it makes total sense and the better this market functions, the better for everybody. It's good all around. I mean, we've got insurance in our name, so we got to get it into an insurance context. Why is this particularly relevant for insurance portfolios right now?

Josh: Right. So I'd start at a high level when you think about “Why is this beneficial for insurance?” It has a lot of the components, credit secondaries has a lot of the components that insurance assets are looking for. Those components are things like predictable underlying cash flows, things like diversification, things like short duration. You have shorter duration assets. So the underlying assets provide those things that an insurance company would benefit from. But I think more specifically, there are a few other components of this. Obviously, that's one: effectively, yield plus diversification is very attractive for an underlying insurance company or an insurance investor. And then another important component of it is capital efficiency. There have been delivery vessels for this product that have been created for IG rated debt, which allow for the lower risk-based capital charges that are really attractive for insurance.

Stewart: Yeah, that's an important point. I think oftentimes the structure matters as much as the underlying. It's important. The return on risk-adjusted capital is a key metric, but we've had other folks come on and talk about private credit secondaries and you talked about this a little with regard to private credit. There's a lot of categories or flavors, if you will, of private credit. I suspect the same is true for secondaries. And I think too, that when CIOs are looking at strategies, it's helpful to know how to categorize, for lack of a better term, who's playing where. So can you talk a little bit about what differentiates Blue Isle's approach in this market?

Josh: Sure. Happy to highlight our differentiation here in the space, and you were nice enough to highlight my background at the top of the call, and I think that is representative of our broader team's background in that we're built directly out of an originations platform. And our credit secondary strategy is similarly is built out of our origination platform. We're not a standalone secondaries business that is allocating to credit. We're actually underwriters of underlying credit and that distinction matters we think enormously as we're evaluating these underlying deals. It's also worth highlighting that we've been investing in credit secondaries for a long time. We've been investing in credit secondaries for over 15 years really since 2009. We have done almost 50 transactions in the space and we actually have, going back all the way back to the great financial crisis, we've been buying and investing in GP-led and LP-led credit secondaries in various delivery vessels through different cycles.

So these are key differentiators. The other important point here is that because Blue Owl has more than 230 underlying investment professionals, we're able to invest across the breadth of all the expertise of the firm. So that includes our direct lending platform, our alternative credit platform, our real estate credit platform, really every flavor of private credit, and that's a key differentiator for us.

Stewart: I think every investor is somehow or the other looking for value in some measure. Can you talk a little bit about how value is actually created in credit secondaries and where do you think, or do you think, investors oversimplify the opportunity somehow?

Josh: Value is created really in three channels and I think some of them are better understood than others. One area where people are immediately guided towards is the discounted entry. And what I mean by discounted entry, we do seek to purchase portfolios at a discount to NAV, and that's a key component of how value is created. Obviously, a discount to NAV creates the opportunity for higher yields and it also importantly provides a real cushion on the downside to credit losses and that's a component of return. Another area of value is the accrued cash flows. And by accrued cash flows, what I really mean are you think about how these deals are priced, they're priced on a reference date and the reference date for these portfolios are often six to nine months before the closing of the transaction. And what that does is in these cash flowing performing portfolios, it allows us to accrue those cash flows and A, further reduce our purchase price at entry, but also it creates additional opportunity for return.

And the last area that's really important, especially on the GP-led side of transactions is structure. We highlighted structure as an important component for insurance businesses when they're thinking about why this is an interesting strategy. The structure also relates to where the return is coming from on these deals. And one of the really attractive things about the GP-led side of the equation, which is where we're spending a chunk of time is we can negotiate directly with the GP for controls. We can negotiate for things like deferred purchase prices, governance, things that can really enhance returns and importantly can enhance our alignment with the underlying fund manager.

Stewart: Yeah, that's super helpful. Thank you. So I don't know, I mean, I don't know if obvious is the right word, but it's a pretty uncertain macro environment and some of that's due to economic data and some of it's due to geopolitics and just some uncertainty in the news cycle. How does that influence the opportunities for credit secondaries today?

Josh: So when you're thinking about uncertainty in the markets and it's a logical question to ask how it affects credit secondaries. And the answer is due to the ways that I highlighted that value is created, it actually creates a really tactical opportunity in credit secondaries. Part of the exercise is pricing underlying portfolios. And when there are areas of uncertainty, whether it be geopolitical uncertainty, whether it be uncertainty in certain industries, whether it be just genuine concern about rates or something happening and even closer to home, that uncertainty allows for us to be more conservative when we're thinking about how to price underlying portfolios and it creates an opportunity for us to do a couple things. One of them is to have a greater degree of downside protection and be more conservative in the way that we think that the duration and the timing of the portfolio will work.

And the other thing that it does for us is effectively allows us to pay less. So the uncertainty actually creates something tactical for us where we're able to capitalize on that uncertainty by really improving even further what we think is a risk adjusted return on these underlying trades.

Stewart: That all adds up to me. It makes good sense. One of the things that happens, and I've mentioned this on several shows, and it's partly because I'm guilty of it, which is I have an understanding of an asset class that's not true, or was true five years ago but isn't anymore. So here's my AI-improved securitist question. I don't even know I'm pronouncing that word right. Are there common misperceptions about this asset class or things that may have been historically true but aren't true anymore? Are there things that you hear folks say that you go, "All right, that's just not the case."

Josh: As this industry has evolved, originally the credit secondaries business was more a series of trades than a business. And what I mean by that is there were a series of opportunities where GPs or LPs would want liquidity, but that primarily came from, as the perception was, it primarily came from, especially on the GP side, there were situations where they had a sense of urgency and wanted to sell. When I think back to the great financial crisis when we were doing these back 15 years ago, there often were situations where someone, whether there was asset liability mismatches, there were banks that were failing, there were forced sellers that created real sense of urgency to be able to buy portfolios of credit in some delivery vessel or another. If you fast forward to today, that perception has waned, but it still exists where people think that the underlying GPs are not strong hands. They think they're primarily in weak hands, which it's just not the case anymore. Today, this is a much more market facing strategy. There are certainly examples where there are less performing underlying assets or less performing underlying portfolios, but there are also plenty of really strong blue chip top tier GPs that are looking to face the market with a credit secondary. And I think that that perception has evolved.

I would also add that there's the underlying question, which is like, why does a GP in credit need to do a credit secondary? The underlying assets actually have terms. They should be able to just naturally find liquidity on their own. And we've just seen this in the deals that we've done. There's a variety of reasons why a GP would actually have to do this. One of them could be the fund structure and the duration of the underlying assets don't match, i.e. The fund makes investments during its investment period, there's a recycling period and during that recycling period, they make a number of investments which basically pushes loans towards the end of or outside of harvest periods.

There could also just be a natural need to make a GP level change shift in the underlying LP priorities. There could be portfolio consolidation. There's lots of reasons that are really good reasons for strong GPs to need credit secondaries.

Stewart: Yeah, that's a great ... I appreciate that. I've not heard, not really walked through that answer and I really appreciate that. That's some helpful insights there. So as we wrap, how should insurers think about the role of credit secondaries in their portfolios over the next couple of years? And I guess there's going to be a difference in this answer of PNC versus life because of the obvious duration differences. It seems to me that if all private credit is originated at a particular maturity, is it true that secondaries will generally be shorter, for example?

Josh: Yes. The expectation is that the underlying assets will have a shorter duration because they're already in the ground and maturing. And I think I highlighted this earlier, but one of the attractive components of this and for insurance businesses specifically is the fact that the underlying assets are already in the ground. There's little to no blind pool risk on the underlying assets because of the fact that, and also minimizes the J-curve mitigation issue because of the fact that you have a portfolio that is mature that you're already acquiring and obviously the fact that they've been in the ground means that the maturity and the duration's going to be shorter. So the answer is yes.

Stewart: I really appreciate that. It's been a great education on private credit secondaries and I've got a couple of fun ones for you in the way out the door. The first one's not necessarily supposed to be fun as much as it is kind of a look inside of the culture at Blue Owl, and it goes something like this. Your career, you've been at some very, very good firms and I've asked this question a number of times. What is important to you when you're adding to members of your team?

Josh: I agree about the fact that I've been lucky enough to work at a number of amazing places. I would say one thing that the places that I've worked have in common is culture, where we really focused on the underlying culture of the organization. When we add to the team and we bring people onto our team, we think a lot about culture. Specifically, I think, we really focus on folks that have a few characteristics that are really a common thread. One of them is drive. We look for people that have real drive and a desire to get things done and another is ownership, where we look for people that have the ability and want to really take on the ownership as if they were the only person responsible for these underlying deals, although that's not always the case. The one other thing that I've found to be really, really a guidepost for people's success is curiosity. So one of the things we're measuring for is are you curious not just about the questions that we're asking you, but also the industry more broadly and how are you articulating that in your life? And I think it's really important to be able to be curious and interested in what you're doing so that you're always looking to grow and improve.

Stewart: That's super cool. I really appreciate that. All right, fun one. You can have dinner with up to three guests. Dinner's on us, by the way, dinner with up to three guests. They can be alive or dead.

Josh: Yeah.

Stewart: Who would you most like to have dinner with?

Josh: Sure. Easy. I think about this sometimes. I just read Mark Twain's biography, fascinating guy, had a long and adventurous life and I think he'd be a really interesting guy to chat with. Another person that I've always been fascinated with is Thomas Edison. He wasn't known to be the most polite or friendly dinner guest, so maybe I'd want to do lunch with him instead, but he lived a really fascinating life also and was just at the epicenter of technology of the day and Edison was involved in so many important inventions. I'd like to chat with him. And then, my grandparents who weren't around and a bunch of stuff I want to tell him. So I'd want that to be the longest dinner of all.

Stewart: I would think that'd be very proud of all the things you've accomplished and I really appreciate you coming on and sharing your insights here today with us on private credit. So, thanks so much for being on.

Josh: Thanks, Stewart. It's really fun. Thanks for having me.

Stewart: My pleasure. We've been joined today by Josh Ufberg, senior portfolio manager at Blue Owl and a member of the Alternative Credit Investment Team. If you like what we're doing, please rate us, review us, on Apple Podcast, Spotify, or wherever you listen to your favorite shows, you can see us on our brand new, kind of brand new YouTube channel, which is growing very quickly, I'm happy to say. If you have ideas for podcasts, please shoot me a note at podcast@insuranceaum.com. My name's Stewart Foley. I've been your host and this is the home of the world's smartest money on the InsuranceAUM.com podcast.