Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name's Stewart Foley. I'll be your host.
Welcome back. It's so nice to have you. Thanks for joining us. Today's topic's a good one, challenges and opportunities in the current PE market. And we're joined by Matt Shafer, Managing Director, Head of Capital Solutions & US Private Equity at Northleaf Capital Partners. Matt, welcome. Thanks for being on.
Matt: Thanks a lot, Stewart. Really happy to be here today.
Stewart: We are thrilled to have you, and great topic. I want to get started the way we always do. Where did you grow up? What was your first job? Not the fancy one. And what makes insurance asset management so cool?
Matt: Taking those in turn, I grew up in a small city in Central New York called Oneida. It's about halfway between Syracuse and Utica. My parents were both educators. My mom was an eighth grade social studies teacher. My dad was an administrator. And I think because of that, the social studies thing, I grew up with an appreciation for the rich history of that area. As the name suggests, it was the current and ancestral homeland of the Oneida Indian Nation, our first allies. They fought in the Revolutionary War with us. And it was also more recently a company town, Oneida Silver. And so I can travel all over the world today and eat in a restaurant in any city and there's a pretty good chance that my hometown's name on it. So-
Stewart: I love that.
Matt: ... I have a lot of appreciation for the history. And I don't live there. I haven't lived there in a long time, but it'll always be home.
Stewart: That's awesome.
Matt: Yeah. The first job, not the fancy one, was in Oneida. I worked in a sandwich shop. It was a better regional version of Subway called Jreck Subs. And so I think every 16-year-old should have the experience of serving food. I think every 16-year-old should have the experience of trying to get the smell of the deep fryer out of their clothes and their hair before they go on a date. And every 16-year-old should learn how to make perfect buffalo wings, which, let's face it, is a life skill.
Stewart: I think that's perfect. I used to work at McDonald's, and my hair, my clothes, my car, all of it. McDonald's has a very unique smell. I'll tell you. Here's a tip for the audience, how to get onions' smell off your hands, toothpaste. You can wash your hands in toothpaste and it will take the onion smell off. And what about what makes insurance asset management so fun?
Matt: What makes it fun for me, the thing I like most about this job just generally is working with smart people to solve problems, to create solutions. Whether that's creating an investment on the money-out side of our business or creating a solution for our clients on the money-in side.
And insurance clients are different. They're different from other clients and they're all different from each other. Each one has its own set of regulatory capital challenges and opportunities. Each one has its set of tax challenges and opportunities. Each one has its risk return preferences and tolerances. And so I love working with people in the insurance industry to craft the right mix of private markets and private equity solutions to suit their needs.
The other thing I find about the insurance industry, and maybe it's the regions it comes from, but the people in the insurance industry are very smart. They're very sophisticated, but they also tend to be down to earth and practical. And as you can guess from the background that I gave you, those are some of my favorite people to deal with in this industry.
Stewart: Yeah. I think there's two things that I believe wholeheartedly, which is that people who manage insurance money are the most sophisticated investors in the world. There's not a close second. And the other thing is that I can't speak for other industries, but we've got a lot of friends in this business, and these are terrific people. There are some really smart and really humble people who are quick to help others with their challenges. I think everybody's very collaborative at the end of the day.
So when I did a little research on your background, and it turns out that you went to Dartmouth. So I grew up in Imperial, Missouri, which a school like Dartmouth wasn't really on my radar screen, let's put it that way. And what was fascinating I thought was I looked up the mascot and the mascot, the unofficial mascot, is the Keggy, right? It's a beer keg.
Matt: Yep, it is a beer keg.
Stewart: I went to the University of Missouri. We would've been proud to have a beer keg as our mascot. How did that come to be at Dartmouth? Is that a real thing? Tell me a little bit about that.
Matt: That is an unofficial mascot, to be clear. And both the mascot of Dartmouth and the mascot of my hometown have been on a journey for very valid historical reasons. The mascots of both Dartmouth and Oneida were Indians at one point in time, and that had to change for very good reasons. And so as Dartmouth became the Big Green, that felt a little soulless. What else do people associate with Dartmouth? I can't speak from firsthand experience, of course, but there were some kegs involved in my undergraduate years. And so Keggy became a very natural evolution of the mascot in question.
Stewart: I love it. I love it. So the topic is that used to podcast is the challenges and opportunity to the current PE market. And I think just for folks who aren't necessarily familiar with Northleaf, I think it would be helpful to get a little handle on Northleaf story and your own of where your focus is and how you became the head of Capital Solutions in US private equity.
Matt: Well, let me do Northleaf first, Stewart, and then I'll weave in my story side by side with that. Northleaf is probably one of the largest asset management firms, private markets asset management firms, that people have never heard of. We've been in business now for well over 20 years. We have a very strong Canadian heritage. The firm was originally started within TD Bank as a way to provide the bank's clients with access to private markets and private equity specifically.
We've grown a lot over the years, and as of today, our clients have entrusted us with over $24 billion of their capital. And what we do is all private markets. It's very middle market-focused. We have expanded the business over the years from just private equity to include an infrastructure business, which we started in 2010, which takes direct and control positions in infrastructure companies and assets. We launched our first dedicated secondaries fund in 2013. We'd been doing secondaries for a long time before that, but in 2013 we started a program, providing dedicated access to that market. We started a private credit business in 2016, which is now a $6 billion business.
And what ties all this together is that focus on giving our investors access to middle market companies and assets, either with an infrastructure focus, with an equity focus at the corporate level, or with a credit focus. But that ecosystem and having all those different vantage points on the massive middle market component of the economy is really powerful. Having credit colleagues who are also dealing with the same private equity firms that we deal with in private equity just gives us another set of touch points and another way of looking at the deals that we do for the benefit of our investors and the benefit of the people we partner with.
Stewart: And are you focused? So just so we're all on the same page, how are you defining middle market and are you focused on sponsored or non-sponsored deals or both? Where are you focused there?
Matt: So middle market first, there are a hundred different definitions flying around. If you ask someone from a “middle market-focused firm”, you'll get a different answer from everybody. For us, it means companies with between $10 and $75 million of EBITDA. Those tend to be transacted upon in an enterprise value between $100 million and $1.5 billion. And they tend to be owned, managed by funds with between $500 million and $5 billion of commitments. And so almost all of our private equity business, whether it's commitments to funds, which we do, secondaries deals that we do, or the direct investments in companies that we do, would fall basically within that range.
So the focus on that is for a reason. We believe that middle market, especially within private equity, has some characteristics that can deliver better returns. There is more impact in a value creation initiative that smart people can have on a company with $15 million of EBITDA, we think, than on a company with $250 million. At least the value creation initiative is very, very different, more growth focused in those circumstances. We think the entry points are a little bit more efficient. We see that pretty consistently. And there are more ways to sell the company because there's just a broader universe of potential strategic buyers and potential financial buyers for a company with $50 million of EBITDA than for that company with $250 or $500 million of EBITDA. So you see that returns can be better in the middle market, but there’s bigger dispersion. You need to know what you're doing in that space. And so there's a benefit to having a whole firm that is focused on that.
To your question about the focus on sponsor-led, that is the heart of our firm within the private equity business that is by definition a sponsor-focused business. Our credit business is probably about 75% financial sponsor lending. But we also have a large and growing and very interesting activity and asset-based specialty finance lending. That's a little bit of a different topic than today's, but it's a neat part of our business that we've built up over the years.
The infrastructure business is different. The infrastructure business isn't sponsor-focused. It is its own sponsor, if you will. But that gives us insight into some really interesting parts of the economy, like renewable energy, digital infrastructure, that creates an important feedback loop into the diligence and access point that inform our investment decisions in the other businesses.
Stewart: And if I'm an insurance company, if I'm a gigantic insurance company, I can get deal flow. But as a smaller insurance company, that's harder. And when we look at with you and your focus, can you talk a little bit about how you're helping your clients access that middle market? And when you partner with these middle market sponsors, what sort of capital solutions are you providing?
Matt: I think there's really two questions in there. One about the money-out part of our business working with sponsors, which I'll do second. The first is on the money-in part of our business and working with our clients to develop the solutions for them.
I think with all clients, but especially with insurance, it's about being able to provide that access in a flexible way. The investments are the raw material that we create with these partnerships with private equity funds and with their companies. But a lot of the innovation that we're doing is how we take that raw material and turn it into the right way of accessing it in terms of the right form that meets the requirements, capital, tax, risk return tolerance, that suits the insurance program.
And so there's this whole range now of ways that people can almost take a tranche of what is essentially corporate value creation exposure as the underlying raw material in the middle market and turn it into something that has the right return characteristics for them.
One thing I should have mentioned in the Northleaf story that's really important part of this journey is that in 2020, we entered into a strategic partnership with a group called Power Corporation of Canada, another really important group that a lot of people haven't heard of. And we partnered with them in an interesting way through their wealth management subsidiary, IGM Financial, and their insurance subsidiary, Great-West Lifeco. So we actually have an insurance company as part of our family, if you will. And part of the reason behind that partnership was that both sides recognized that private markets were going to be increasingly important to both insurance and to wealthy people, to the wealth management channel. And so partnering made complete sense. And we spent a lot of time working with both of those organizations, in particular Great-West, to craft solutions that work for them.
Stewart: That's really interesting. Let's talk about the secondaries platform. It's interesting you brought up NAV lending. That does seem to be an area that is getting traction. And the other one that I hear about and we've done a podcast or two about is secondaries. So can you talk a little bit about the secondary market at a high level and then let's talk about how Northleaf in particular is active there.
Matt: Yeah. No, happy to do that. And I'll weave in a little bit of my personal narrative because I didn't mean to duck that story, but I think those are they do go together and it ties to secondaries.
So as others have noted on your podcast, the secondaries market has grown from being a cottage industry 20 years ago, a couple billion dollars a year, to being an over $100 billion market today. And it used to be just a trade in LP interests. So someone who has an LP interest in a fund sells that LP interest to another LP. And our business when we started out 20 years ago was just doing that. Over time, a lot of innovation has happened in that market. The most important piece of innovation has been the GP-led continuation vehicle where the sponsor takes a company or a package of companies out of one of their funds, sells it to secondaries funds, and provides the liquidity to their investors. That has gone from, well, I did one of the first deals at my previous firm. And in 2012, there was probably maybe $1 billion dollars of total continuation vehicles done that year. And last year, it was something like $55 billion. So that gives you an idea in 12 years how much that market has grown.
Stewart: But did I hear you right, that you said that Northleaf started in secondaries?
Matt: Northleaf has been involved in secondaries from the beginning of the firm, from about 2003. We probably did our first secondaries deal in that timeframe. So we've been involved in the market from the beginning. Others started that market in the late '70s and '80s, but it's always been at the heart of our business.
What has happened as the market has grown and as those capabilities across the market have grown is we've grown our business to match that. I was hired by Northleaf in 2018 to do a number of things. I started an office for us in New York, but mostly to augment our secondaries capability. Having come from a more GP-led background, we had done a few, but we wanted to augment that capability. And that is how my story in Northleaf intersect. So we've gone from having a small number of people across our private equity business doing secondaries as some of the things or one of the things that they did, to having 30 people in our private equity business, half of whom spend the majority or all of their time on secondaries. We've expanded our team, but we've stayed small relative to the market.
And this is one thing you have to understand about the secondaries market. It's very concentrated. There are about 12 firms today, who have about 80% of the dry powder in the secondaries market. We are not one of them, or our market share in terms of what we buy is consistently less than 1% of the market. We consistently transact on less than 1% of what we see. And we like that because it allows us to focus on what we know, what we're familiar with, and where we really like the return profile and not feel like we have to just buy beta in the overall market.
That's not a bad business, by the way. That's a good business and it has driven the growth of the market that it exists, but we offer something a little different, which is a more curated and a little bit more focused approach that the secondaries.
Stewart: And can you talk a little bit about the benefits of secondaries for insurance investors? And let me give you my uneducated approach. One of the aspects is that you eliminate the J curve, right? And maybe it would be helpful to just explain what that means by helping our listeners understand what's meant by the J curve.
Matt: Yeah, so I think let's start there. And there are other benefits to secondaries as well, but I think that is an important foundational point to understand.
When you buy a buyout fund, you're typically buying closed end 2% management fee, 20% carry, but that 2% management fee on committed capital means that from day one, you're paying a fee. Then the private equity firm, over time, goes and invests that capital in assets that tend to be kind of flat with the value that they buy it at for a year or so before all the growth initiatives and value creation initiatives start to bear fruit. And then you see an increase in value after that. So your return as an investor actually starts by going down a little bit and then it comes up and hence that kind of J shape. With secondaries, because you are deploying the capital from day one, and because you are usually accessing it at a discount, you are getting immediate uplift in the value of what you're buying, which mitigates the J curve to secondaries investors. And we have historically in our secondaries program not encountered J curve or our investors have not had a J curve in their fund experience. So J curve mitigation is an important benefit of secondaries.
Other benefits, vintage diversification because you're accessing a portfolio of different funds which invested at different points in time, you're getting exposure to deals that happened yesterday, today. Some of that's in the price, but you're generally accessing that in a discount. So you're buying it at an efficient price relative to the intrinsic value you're getting, of course other ways of diversification by manager, by geography, by industry, and you are getting relatively capital efficient, quick return of cash because you're underwriting mature assets. So a new buyout is entered into with the expectation that it's going to have a five-year life. It's tending a little longer than that right now. With secondaries, you're buying stuff that is already progressed on that journey and so should return your capital within a shorter period of time than a standard buyout fund.
And so what we're seeing with insurance clients and with other clients is a movement from using secondaries as a point in time to get maybe make up for lost time in their private equity program, buy prior vintages, manage J curve, or play dislocation. It's moving from that tactical allocation into a more strategic, ongoing, regular allocation because those characteristics really complement a private equity program that provide a different kind of exposure, more capital efficient, more diversified exposure that compliments a buyout program.
Stewart: You mentioned that the J curve is only one aspect. What else would you mention about secondaries? Because we've got one more thing to cover and I just want to make sure that we've completely covered secondaries.
Matt: Yeah. I would note that today, I think secondaries is a market or a strategy for all markets. Today offers an interesting point in time because one of the great needs out there, and the challenge is that people need liquidity because of the change in the debt cost paradigm, the rates paradigm. Exits have slowed down pretty meaningfully. They're running at about the same level that they were in 2013, but the industry is 3.5 times the size of what it was in 2013. And so people are feeling like they want to continue deploying into private equity because they understand the benefits of the asset class, but to do that because they're not getting the exits from their buyout portfolios, they are using the secondaries market to get liquidity and use that liquidity to redeploy into the asset class.
Now, one of the things you have to keep in mind about this market is it's not really a distress market. It's really a market that functions when you can get something like 90 cents on the dollar for the positions that you own. And so supply creates its own demand. And right now with a less than two year overhang in terms of capital availability relative to deal deployment, there isn't enough money to support a big increase in adoption of people using the secondaries market as a liquidity tool. There's more potential supply than there is capital. And so we think in a sense that the capital will create the demand by underpinning that ability to transact at 90.
At a point that you make, Stewart, I've heard you make before that I love is that as the secondaries market continues to grow and develop, it is going to increase the adoption of private equity as an asset class.
Stewart: Absolutely.
Matt: Because the ability to make that decision to buy into something when you're not locked into a 10-year commitment to a closed end fund but actually have a way of getting liquidity at a reasonable price is one of, I think, the biggest growth drivers for the industry as a whole.
Stewart: Yeah, I think it's private assets across the board, right? Private credit, same thing could be said there. I think one of the things that insurance companies always struggle with is where's the line for how much liquidity I give up in my portfolio? Because obviously liquidity has a cost, and if you hold a whole lot of liquidity, you're going to underperform your peers who are holding less, right? So you can get paid for the illiquidity. But the downside is that if you don't have the liquidity you need, that could be catastrophic, right?
Matt: Exactly.
Stewart: So there's places like the federal home loan bank that have liquidity facilities that are collateralized by resi mortgages that can be helpful there. But an active secondaries market in private assets to me makes CIOs feel like, "Hey, if my circumstances change and I need to pare back my allocation because there's a correction in the public markets or whatever it may be, that you can do that.” Without getting, the unsophisticated term I've always heard is getting your face ripped off by exiting. So I do think that it's encouraging that the secondary market and private assets continues to grow. One person's opinion.
But so let's talk about structured equity opportunities. Can you talk a little bit about the structured equities opportunity, give us the background on that market, and just talk about where you think the opportunity lies?
Matt: Sure. And stepping back a little bit again, we're accessing private equity through primary commitments to funds through our investments in the secondaries market and through direct investments into the private equity portfolio companies. We don't do control buyouts. We invest in other people who do. So our capital, and this ties to the structured equity story is complementary to the buyout funds that we're backing across our program. We have very broad access. We're in over 300 funds with over 200 managers. We actively cover 900 managers, all middle market. And so we have this system which allows us to see where the opportunities are.
One of the opportunities that we're seeing, and to be fair, we saw this when the market was good and we also see it now that the debt markets are more expensive and the market's more challenged, is to invest directly into private equity portfolio companies to support their growth. That has arisen in large part because of the increase in rates. A company that was bought by private equity in 2021 typically would've had six times leverage on it, 6 times cashflow or EBITDA. And what you've seen just in the increase in the base rate, nothing else changes. The company's available cash after paying its interest bill has gone down by half. That's before capex, before working capital, any other growth investments.
And so what private equity is facing is a situation where they're owning companies for longer, and those companies don't have as much cash to reinvest in their growth strategies as they did before. So that creates an opportunity and a need for outside capital to come into those businesses, not take control. Minority equity is a great way to do it. And it sounds really hard and complicated with structured capital or preferred equity used interchangeably, but really all it is is putting in an instrument that sits between the debt and the equity. Importantly, it doesn't pay cash interest. So the interest, the contractual return rolls up and is PIK-ed. It tends to come with call protection, and it tends to come with some form of equity participation that enhances the return because you as an investor need to be compensated for deferring that cash interest obligation, that yield.
So what you get out of all that is an instrument that tends to be ranking in front of about 50% of the value of the company. Our deals typically have 40% to 60% of the value of the company ranking behind us. That existing equity doesn't get paid until we get paid. So you have great alignment with the owner of the asset, and the owner of the asset gets interest-free capital that they can use to grow their business. And so you're creating a win for your investors and enabling something very important for your partner.
We've been active in that. As I said, we did a lot of this when debt was cheap and the markets were flowing. Those deals generated pretty good returns, high teens, low twenties. And we're seeing even better returns today as you'd expect given the shortage of capital in the debt markets. So if I step back and think about that as an allocator, what you're offering investors with a structured equity program is the opportunity to get pretty good returns not that different from private equity. You're not foregoing that much of the upside, but you are entering the capital structure of private equity-owned businesses with half the value or more ranking behind you. And we think that's a pretty good way to get private equity exposure and deliver very good, not just risk adjusted returns, but absolute returns in today's market.
Stewart: Well, we are coming up. I've learned a tremendous amount about your world today, and I think our audience has gotten a great education and I want to thank you for that. What would be helpful I think is could you give us a couple, maybe two, three takeaways that based on everything we've discussed today that our listeners can take with them. And then I've got a fun question or so for you out the door.
Matt: So first of all, private equity as an asset class is going to continue to grow. It's going to continue to be very important part of people's allocation mix. I think there's broad consensus about that. But what's really interesting is the ways that private equity is being made available. It used to be you had to buy a buyout fund. Now, you can buy a buyout fund, you can buy a secondaries fund, you can buy a closed-end fund, an open-ended fund. You can buy a CFO tranche. You can buy credit. You can buy NAV lending. So the ways of accessing the raw material of the private equity industry are going to continue to drive growth to insurance and other investors. That's point one.
Point two is the secondaries market functions as a core part of people's allocations and complements their private equity exposure with J curve mitigation, yes, but also diversification and capital efficiency.
And then the third thing is that structured equity is going to be an increasingly important part of the market by helping people continue to grow their portfolio companies in a time of higher rates.
Stewart: That's outstanding. Thank you so much. I really appreciate that, the education for you being on. We have optionality on the way out. You don't have to take both questions. Lots of our guests do. No pressure. What advice would you give a 21-year-old Matt Shafer and who would you most like to go to lunch with, up to a table of four, alive or dead?
Matt: The 21-year-old Matt Shafer is invest your time in relationships. Think about networking and relationships as compound interest. The more you do, the earlier on, the more you end up with at the end. That's clearly the advice I'd give 21-year-old Matt Shafer.
Lunch, I answer this question differently at different points in my life, but today with what I'm focused on is I evolved from deal guy to business leader. It's also been in the news recently. I'd have lunch with Nick Saban because to me, what he has achieved over the last 17 years just makes him the Jedi master of sustained organizational excellence. You think about the degree of difficulty, the level of competition, what he had to do from recruiting great talent, keeping great talent, putting a system in place. And then the best thing that he did is he changed the system even though it worked to keep up with a changing environment. And so I think I would just learn so much about how to run a world-class organization from having the opportunity to pick his brain.
Stewart: Wow, I love that. That's great. That's fantastic. We've been joined today by Matt Shafer discussing the challenges and opportunities in the current PE market. Matt's the Managing Director and Head of Capital Solutions & US Private Equity at Northleaf Capital Partners. Matt, thanks for taking the time. We certainly appreciate it.
Matt: Stewart, thank you. It's been a pleasure.
Stewart: Thanks for listening. Please rate us, like us, and review us on Apple Podcasts, Spotify, Google Play, or wherever you listen to your favorite shows. My name's Stewart Foley. Please join us again on the next edition of the InsuranceAUM.com podcast.
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