Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name’s Stewart Foley and I’ll be your host. We have got a great podcast for you today, a guest that many of you’re going to know, very smart money in the room. Phil Titolo, who’s the head of Direct Private Investments at MassMutual. Phil, thanks for being on. Thanks for taking the time.
Phil: Hey, Stewart. Yeah, no, appreciate you having me on. Looking forward to our conversation.
Stewart: You’re just laughing because I screwed up the intro 3 or 4 different times and now this is the take that we’ve finally gotten it to go. So I really appreciate you being on, and I think our listeners get a lot out of knowing; you have a very interesting vantage point and you and I had a chance to talk last week when we were at a conference in Florida. I like to timestamp these podcasts because markets are moving so quickly. So it’s Wednesday, April 5th, and we had a nice chance to talk and get to know each other a little bit last week, and then you were kind enough to come on this week for this. So thank you. Before we get going too far, I want to start this one off we start them all. What’s your hometown, the one you grew up in? First job, not the fancy one, and a fun fact.
Phil: Yeah, so my hometown in upstate New York called Saratoga Springs, known for either Skidmore College, people recognize, there’s the performing arts center, SPAC, or the racetrack, really well-known horse racing track up there. My first job was actually at that racing track, parking cars and not parking cars, like a valet, parking cars with a flag, trying to get people to park for $5, $10 on various people’s lawns. It was good work.
Stewart: An entrepreneur at an early age.
Phil: I was working for the family who owned the lawn. But, no, I had a lot of interesting jobs when I was very young. I was a referee for soccer. I also referee dodgeball for a while, a little fun fact.
Stewart: There you go.
Phil: Yeah, yep.
Stewart: So what is the fun fact? Is it, Dodgeball referee is a fun fact.
Phil: Yeah, that’s what I’m saying. That was the fun fact.
Stewart: Oh, that’s the fun fact. There we go.
Phil: Yeah, yep. Playing and then refereeing dodgeball.
Stewart: All right, so you are in an interesting seat and you see interesting investments. When we were talking, we were about asset classes that I’m not deep on by any means. Can you talk a little bit about how institutional investors see their asset allocation decisions?
Phil: I’m happy to, let me just start off by these all my personal views, right or wrong, they’re mine. I’m very fortunate to be at MassMutual, which is a private mutual life insurance company based out of Massachusetts. I came here eight years ago and before that I was at the Hartford Insurance Company and I spent time both at Credit Suisse, which RIP, and at United Technologies now called Raytheon’s Pension Plan, where I got my start. Throughout that whole period, I’ve always, all the great leaders and mentors along my career have really instilled in me an asset liability matching kind of framework that goes back to LDI and the pension world as well as the ALM that drives insurance company balance sheets and liabilities. What I’ve noticed throughout the years is I see institutional investors, for a variety of reasons, whether it’s for reporting purposes, efficiency, just being able to divide up the investible universe, come up with different buckets in asset classes.
The problem with that is there’s a lot of interesting stuff as capital markets evolve and move that don’t fit neatly into any one bucket, and that to me is where you can really find a lot of value. It’s not easy to do because one, you got to find them. Two, usually they’re early stages in that they’re niche asset class development and obviously you got to have at least some resources in an investment team to be able to do the heavy lift. You kiss a lot of frogs to find the one unique opportunity that really fits in between the cracks of asset allocation buckets. I understand why a lot of institutional investors do the asset allocation bucket mentality, but there’s a lot on the gray area that I think we could all benefit from for our returns.
Stewart: And if I’ve got this right, that’s where your team focuses specifically, right? You’re looking at the – ‘special situations’ is maybe an overused term, but you’re looking for unique situations. Is that a fair assessment?
Phil: Exactly right. And notice how I didn’t say what form it was in. So our team is charged with doing everything from a separate account with investment grade, infrastructure debt. Our investment team also looks for unique asset backed opportunities. That’s on the debt side. So alternative debt that’s kind of in the cracks, but also if you go into the equity side or fund side, everything from distressed debt, we’ve done niche real estate like self storage. We’ve done some co-investments alongside some great managers. Those are the kind of opportunities that I think a lot of times get overlooked because they don’t fit neatly into one specific bucket.
Stewart: And one of the things that we talked about, and you had brought up in some of the comments that you made was, you talked about the last 2 decades being really a central theme as bank disintermediation, that trade. Can you talk a little bit about how you view the bank disintermediation and with the banking situation that’s going on, how you think that fits together?
Phil: Yeah, happy to. So typically when an asset manager or an investment team have a really unique idea, where’s the first place that they kind of go to work with? They go to their incumbent banks. Their banks see a lot of flow that they can do things on their balance sheet. They obviously, especially on the debt side, are key players or have been key players in various transactions. A lot of times those banks will be the early adopter of niche asset classes. But the problem is that the way the banks are structured, their ALM mismatch between the daily deposits and what they’re trying to do on their investment side don’t always match up well. And sometimes those are where you’ve seen these bank disintermediation trades really since the GFC. But even before then, going back to CLOs, CLOs were originally done mainly on bank balance sheets or forms of them, and then they became kind of an institutional asset class.
You’ve seen that, like I mentioned, the infrastructure debt, infrastructure debt used to be done on bank balance sheets. Now there’s a variety of talented teams doing infrastructure debt in the marketplace. Private ABS is another one, but I think that’s only going to continue from what banks used to stand in between end users of the capital and providers of that capital. I think you’re seeing now they come off banks balance sheets and go more directly between the institutional investors and really private asset managers who can fill those little gaps but not do it using a bank balance sheet. There’s a lot more alignment there between a closed-end fund that has seven eight-year life to them, where all the investors have committed capital and are locked up the whole time. That’s a better, you think about it from an ALM perspective, concept for really taking advantage of those niche opportunities.
Stewart: So I’ve asked this question to others about the development of public credit markets versus private credit markets. This is my own opinion. I don’t see banks lending more or that the credit’s going to get easier through banks, given what’s going on. It seems like there’s a tailwind and what will be a persistent need at least at current levels, but likely growing for a need for private credit markets. Does that align with how you see it as well?
Phil: Absolutely. I think there’s been a misnomer amongst institutional investors who frankly look at the flows that go into, let’s just say private credit in a more general sense that conclude direct lending, private ABS, more niche lending strategies. There’s been a ton of capital raise there over the last, call it 5, 6 years, and folks look at that as, “Oh, is that a problem? Is there a bubble?” I think of it as more of a longer-term cycle between bank lending, the public debt issuance and the private asset capital formation that is taken advantage of these private credit. I don’t see it being a problem. I think there’s still a pretty significant imbalance between the amount of capital that private equity funds have raised and the dry powder that they have. And the dry powder and funds raised in the direct lending market, for example.
If you think about it at pre-GFC, the numbers were actually flipped. Meaning for every company was pretty much the capitalization was 60% debt, 40% equity provided by the PE. That’s flipped now with multiples of the last 2 years still being pretty elevated. The debt’s holding tight at, call it 40% of the capital stack, but the equity’s putting in more. Because of that, there’s a lot more capital need for that lending as activity picks back up. And so I think there’s not really an appreciation for how much private capital is needed in private credit land. It’s just a matter of who’s doing it, what’s their underwriting standards, what’s their sourcing, what’s their angle in the market? Those are all factors that obviously need to be taken into account.
Stewart: This seems to me that private credit is going to be an integral part of keeping the economy moving forward here as banks appear to be perhaps pulling back even further. It just seems like there’s so many deals that are not getting financed through banks. It seems like it’s becoming more and more mainstream. I don’t know if that’s… This sound right?
Phil: Yeah, I think that’s right. What’s interesting is, I was having this conversation at dinner last night, we’re the direct lender and we were talking about the banks and I made the point that I think folks, banks are not going away. We will have a banking system. What they do with their balance sheet is still kind of, I think, in flux. SVB is a classic example of 2 things. One, obviously the ALM mismatch that’s been reported that hedging wasn’t fully there. That’s obviously something insurers do every day and are obviously integral to our businesses. But the other component of SVB, I mean they got a lot of deposits in, they bought treasuries. What company in history has had a problem or gone under had to be taken over because they bought US treasuries. I find that to be unique on the asset side of the balance sheet for SVB.
But on the banking system in general, in general, banks are pretty levered, right? They’re, call it 15 to 1 on average from their balance sheet perspective. Let’s just say you took all that capital away and put it with other financial institutions, insurance companies, pension plans, et cetera. There’s not really that leverage there as well. So there would be a significant credit issue I think in de-leveraging in the system if banks went poof in the night. So I don’t think that’s going to happen, nor should it. But I do think it’s interesting to see over time how the asset mix on banks’ balance sheets and what they’re willing to do, what they’re able to do, how does that change? And I think as its institutional investors, it’s important for us to keep a finger on the pulse of what is changing and where are there opportunities to engage with managers that have unique angles into those areas that the banks are slowly leaving.
Stewart: That’s awesome. Thank you for that. Moving to the next topic here, you and I have something in common in that, and we didn’t know it I don’t think, but we both are kind of crusaders, if you will, for insurance companies as really good places to work, particularly in the investment function. And I think that insurance companies have, I think historically, been painted with an unfortunate brush of being slow-moving and antiquated and whatever else. And when I talk to people like you and we just had Patricio Urciuoli from Liberty Mutual and many other CIO-esque folks, it’s a smart money conversation. So can you talk a little bit about, from a career perspective, I want to give you the floor here to just kind of talk about your… Because I think you’ve got some passion here, right?
Phil: I definitely do and it’s funny, like I mentioned, I started at United Technologies now called Raytheon Pension and LDI is central and critical to their management of their plan. Charles Vendelif, Robin Damani, they were some of my early mentors and still are today. Private pensions are definitely ALM-centric with the residual staying with the beneficiaries. Insurance companies are same concept for ALM, if it’s a public insurance company then the residual goes to the stock owners. In a mutual where I’m at the residual goes to our policy owners. And really that’s the alignment that I love working for a private mutual company. I’m a policy owner, so technically I’m a very, very, very small owner of our company.
But that alignment feels really good and allows us really to invest on the asset side for very long periods of time to match our liabilities and not be worried about the quarter-over-quarter dynamic in the public markets. I don’t think many people come out of undergrad, and I’ve talked about this thing, I want to go work for an insurance company investment management team, and I understand that, but I do think there is a general sense, especially young people, that insurance companies are a slow-moving kind of more antiquated institutional investor, buy bonds and just let it be. One of my career goals is definitely to promote how insurance companies can be a more direct force in the capital markets.
Because the capital markets are constantly evolving and I think there are, as I mentioned with the buckets and finding the gray space in between, there’s a lot of potential to capture different value premiums and for MassMutual being a mutual, that directly goes to our policy owners. And it’s important to find those angles and those niche opportunities before those premiums get arbitraged away in the broader market. That to me is what I want to do with my career is try to raise that awareness of how all insurance companies can do that and have that view rather than solely being more of an allocator that kind of sticks to the traditional core that doesn’t really evolve.
Stewart: And it’s interesting, I mean there was a guy that I used to work with named Jim Bachman who gave me this equation and it’s return on assets times the ratio of invested assets to surplus, plus the one minus the combined ratio times the net written premium to surplus and that turns into ROE. But the interesting thing is that there’s surplus in both equations. It’s the same surplus, see the wind blows and that impacts your surplus negatively. You have a credit default, that impacts your surplus negatively. So the assets and liabilities of an insurance company are inextricably linked. And so when you’re investing, how does that relationship play itself out in your strategic asset allocation, for example?
Phil: So I will say that we are very fortunate at MassMutual to have an incredibly talented and strong asset liability management team. They really are the backbone of what allows our broader investment team to go look for these unique opportunities. Some of them do need to be thought of or placed into different segments to match the liability there, but you don’t have a team there that really can help you find the right home for the unique assets you’re finding, then it doesn’t really work. I do think it’s important for insurers to obviously keep in mind the risks that they’re taking but not take risk solely because whatever rating agency puts on that, I think what got a lot of insurers in trouble and just investors in general pre-GFC, is people were buying things based off of ratings. There was a measure that I had remembered someone early in my career telling me spread divided by credit rating as a number.
That concept, I mean, a computer can do that. There’s no real intel needed and to me that doesn’t work. People are wrong. Reading agents can be wrong or miss something. At the end of the day, it’s your capital for your constituents and you need to really own that risk regardless of what a rating agency or other institutional investors say. That’s been really a new unique realization that you just got to do the work yourself and your team and really dig down to the key drivers of what’s the return profile as well as any of the underlying risks.
Stewart: That’s terrific. So turning to the credit cycle. Where are we?
Phil: I wish I knew. But I’ll tell you one thing. I have a law degree, my background, and there’s been a lot of talk about covenant light and the degradation of covenants and documents in the lending space. I do think that is going to, again my personal opinion, I do think that is going to keep reported default rates lower because frankly, if there’s no covenants in the docks, other than maybe a maturity default, how are you actually going to have a big default? So I think the default rates are actually going to be lower than we expect, but because of that concept of, “Well, there’s no real teeth to these documents as companies maybe in trouble and should have already defaulted,” they’re going to kind of kick the can along.
I think eventually what happens is those become either zombie companies, we can talk about zombie companies if you want, but those become companies that are really only just trying to service the interest costs on their debt and they’re not really generating much value for their equity. It becomes more of an equity optionality play. But that means that recoveries are going to be lower than we expect, so lower defaults than probably what folks are expecting to see on a top-level basis. But I think in aggregate, the recovery rates are also going to be significantly lower than what we’ve seen historically.
Stewart: It’s interesting because you mentioned a book to me. I think we were, is it-
Stewart: Japanisation and you talked about zombie companies.
Phil: Bloomberg Press.
Stewart: Yeah. So can you talk a little bit about the high points of that?
Phil: Yeah, definitely. So the rise of this term ‘zombie company’ actually started in the lost decades of Japan in the 90’s. So where companies that probably should have gone bankrupt or weren’t really driving any economic value for its shareholders, the banking system and the lenders let those companies kind of just amend and extend for very long periods of time. Just to the point where they could just barely make their interest costs in Japan. Part of the dynamic there was they were trying to allow the company managers to save face, pride and not have to effectively just lose the company. But that was really a drag on economic value because companies that shouldn’t have existed, didn’t have the right competitive force, were ones that were still in the marketplace. So I think that’s really the genesis of this concept of zombie companies. And if you look over in the US particularly, it’s the same phenomenon happening in Europe.
There is an increasing rise of zombie companies, meaning they just barely can cover their interest costs. If you strip out the growth companies, it’s a lot lower, but it’s still a meaningful part of the economy. They typically peak in number right before there’s a significant downturn in the broader economy. And in my mind, that’s really when monetary policy gets tighter, lenders don’t have as much leeway to amend and extend forever and they want to just call it what it is. That’s something that I’m watching to see if and when that starts
to happen. But that book, Japanisation, is a great example. Unfortunately when I read it gives you déjà vu because a lot of the government actions and market dynamics that happened in Japan in the 90’s and in the early 2000’s, you’re going to be like, “Wait a minute. That sounds very familiar to the past 10+ years in the US and the story’s not over.” So there’s a little bit of that that’s definitely is concerning.
Stewart: And maybe the wrap question right, is you mentioned that you’re frequently asked where you see froth in the markets, and I’ll maybe put it in another way. When you look out at this market and the economics and the geopolitical and whatever else, what do you think is mispriced either over or under?
Phil: Yeah, so obviously I don’t see everything, but the areas that I’ve seen time and time again that I don’t understand the thesis behind or don’t see the end return profile playing out. A lot of folks are concerned about the lower end of the high-yield market, triple Cs. Definitely would agree with that, but I think that’s kind of consensus view more or less. A lot of folks I hear on the institutional side say, “I’m not touching office, I’m not touching retail hospitality.” And so I think there’s a lot of consensus there as well. What I see that are not on people’s radars or not as much as I think they should be, something called ARR loans. These are called Annual Reoccurring Revenue loans. In my mind, they’re venture debt and what they do is they lend that a multiple of revenue not on EBITDA, because EBITDA is negative.
Those types of companies are really in growth mode, some are real VC companies, but they’re being lumped in with traditional cash flow loans. And I think that’s risky because in order to have cash to satisfy your interest payments on that, you need to be able to pull from your equity. You’re effectively using your equity dollars to pay for that interest cost. We’ve seen the tech equity wave tide go out and obviously SVBs run into some trouble. The tech lender, I think the ARRs are a very risky space that I think folks are going to realize that does not have the same risk return profile that a traditional cashflow lending portfolio would. Other areas, Stewart, I think I’ve heard a lot of folks figuring out what to do with office space, rightfully so. I don’t know what to do with office space that that’s not being utilized.
Some folks are converting it to lab science. I think that’s risky to a degree because a lot of the companies that are the tenants in those are maybe smaller healthcare companies that are working on different treatments and new lab technology. I’m not sure how that all plays out if the market turns and there’s a downturn in some of those healthcare niche spaces. And then lastly, in the sectors I mentioned that I think are risky in the real estate space, one that I hear people say that they’re hiding out in is multifamily and industrial. I do think there’s definitely some risk in the industrial side.
Unless we’re all going to only buy things from Amazon and get everything delivered and a nice little package set on ride my porch every day, unless we’re going down that route. I think some of the assumptions in the industrial real estate equity part are definitely something that I think are a little too optimistic. Not sure, I think they’ve got a great location. I think they’ve got a definite need in the area, but the costs that it takes to invest in that property might not be something that’s going to yield a substantial return. So those are the areas that I’m seeing potentially not be on people’s radar that are may or may not turn out to be how I’m seeing them, but definitely in areas that I think folks should be aware of.
Stewart: Man, I love it. I learned a lot. I learned a lot sitting next to you at dinner. I learned a lot talking to you at the event and I’ve learned a lot this morning and I really appreciate it. I’ve got one-
Phil: It’s okay.
Stewart: There’s a new… Thanks, man, I appreciate it. New for 2023, Phil, this is my new closing question. Ready?
Stewart: I don’t know, I asked ChatGPT to come up with some closing questions and this wasn’t one of them, but here we go. Who would you most like to have lunch with, alive or dead?
Phil: Yeah, so I love this concept and I would say it would either be Paul Volcker or Alan Greenspan, and here’s why.
Stewart: Oh, wow. There you go.
Phil: But I would love to have both of them came to lunch. The reason why is neither were elected by the people, but I dare you to find another set of individuals who had more influence on our day-to-day lives across this entire country than those two. To me, that’s remarkable-
Stewart: I think so too.
Phil: … and it’s an incredible power and the fact that they, in my view, responsible with their power and carry their duties out in professional and responsible way. I mean, you can make arguments about what their actual decisions were and how their implications were, but the fact that they discharged their duties professionally and with rigor, to me, I would love to hear that dynamic and hear kind of what went through their mind during those periods.
Stewart: Wow, that’s a great answer. I love that. I would love to have lunch with Paul Volcker as well, that would be super cool. So listen, thanks for taking the time.
Phil: Thank you so much for having me.
Stewart: Yeah, it’s been great. I hope you’ll come back on and hopefully we’ll see you this summer. We’ve been joined today by Phil Titolo, head of Direct Private Investments at MassMutual. Phil, thanks for being on.
Phil: Stewart, thanks so much. Appreciate it.
Stewart: Thanks for listening. If you’ve got ideas for podcasts, please shoot me a note at firstname.lastname@example.org. If you like us, please rate us and review us on Apple Podcasts. We certainly appreciate it. My name’s Stewart Foley and this is the InsuranceAUM.com podcast.
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