Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name’s Stewart Foley, I’ll be your host. And today we’re talking about private credit with Bob Morgan, managing director and chairman of the investment committee at 50 South Capital, part of Northern Trust. Bob, welcome.
Bob: Thanks, Stewart. Great to be here.
Stewart: It’s great to have you. It is widely acknowledged that insurance companies have already made the decision to invest in private credit. So the key issue today is how to invest. But before we go there, I want to ask you the same questions that we ask everybody, which is, what’s your hometown? What’s your first job and what’s a fun fact?
Bob: All right. Let’s see. Hometown, Huntington, West Virginia, right on the Ohio River in the western part of the state. My first job, you probably get this one a lot, I’d have to say it was mowing lawns, made some nice cash, pushed the mower all over the neighborhood. And then my fun fact is I guess somewhat linked. I’m an identical twin.
Stewart: Is that right?
Stewart: That’s interesting.
Bob: He was my first business partner. We must have mowed every lawn in Huntington together at some point or another. So I’ll link those two – first job and fun fact.
Stewart: That’s interesting. So not everybody knows how 50 South Capital operates, but you are effectively an allocator. You approach private credit from a slightly different angle. So can you talk a little bit about how you approach private credit and how you actually come at it as an allocator?
Bob: So 50 South Capital, for your listeners who aren’t familiar with us, we are a wholly owned subsidiary of Northern Trust, which is one of the world’s largest custody banks. And the asset management business of Northern Trust is about $1.2 trillion (Source: Northern Trust Asset Management, as of June 30, 2022). So, it’s just a very large-scale asset manager. It’s a great platform for our business 50 South, which is focused exclusively on investing in alternative assets. So, that’s what our team does. We invest in hedge funds, we invest in private equity funds, and that includes venture capital funds, buyout funds, co-invest, secondaries, and then obviously private credit.
We have a team that’s been at 50 South for 22 years and we have about 50 professionals and oversee just over $13 billion in assets (Source: Northern Trust Asset Management, as of June 30, 2022). And so you’re right, yeah. We invest in funds and that’s, a lot of people say, call it being an allocator. So we’re probably like many of your listeners, instead of investing directly in the loans, the private credit loans that are being made, we’re choosing managers to invest in those loans on our behalf. And it’s not just in the private credit space. That’s the same strategy we use with our hedge fund business and our private equity business. So we design fund of funds that package these together or we will structure custom accounts for larger family offices or institutional investors.
Stewart: And so I have always heard that a multi-manager fund costs more. Is that true? And can you talk a little bit about the cost structure and why it’s not always the case?
Bob: Yeah, that is true. I think when you ask most people about fund of funds businesses, there’s an added layer of fee because the investor’s not only paying the underlying manager fee, they’re also paying the fund of funds level fee, but that’s not always the case. And, I think there’s a lot of benefits to this fund of fund structure across alternatives and specifically private credit. I think there’s a few reasons for this. I think the first, from a cost perspective, simply is that scale allows you to negotiate better fee structures with underlying managers. So if we can accumulate enough capital from investors and pool that to have a larger pool of capital to invest, it gives us greater negotiating leverage with the underlying fund manager. In this game, in a private credit game, you’re trying to hit singles, and fees matter. Every little bit that you can negotiate at that fee level is impactful to the ultimate return of the investor.
Aside from scale, we found a couple other things that really help us in the negotiations on the fees is one, just being a strong partner, it’s like the Guinea thing, people like to work with other people that they like and having long relationships certainly help, being a good partner, trying to be value added for the firms you’re investing with, having deep knowledge of the space, all of that can really impact how the negotiation goes and how that relationship works. The other thing I would add from a cost perspective, and this depends on the investor, but you’re getting broader diversification across private credit, but you’re getting it all through one vehicle. So all of the capital calls are managed more efficiently and you get one quarterly report instead of several if you’re investing in a bunch of different direct managers.
All of that really makes the administrative efficiency of this quite nice. And so, you have lower admin fees than maybe building your own staff to manage all the separate direct investments. And then finally, something we’ve done is just because of the diversification we’re getting in our fund structure, it allows us to get some, we get a capital call facility, that I just mentioned, that helps make management of cash a little bit more efficient. And you can, with private credit, we could talk more about this, but you can put some leverage on it just given the safety of this asset class. And so, we can put a term loan facility on our fund that allows us to borrow cheap and lend at a higher rate, which gives us a nice yield enhancement. So there’s a lot of pieces that come together in this, but when you package it all together, we believe it is a much more efficient way for many investors to invest at lower fees than they would actually have going direct.
Stewart: What about carried interest? There’s a point here about the ability to eliminate carried interest. Can you talk a little bit about that?
Bob: Yeah, carried is an interesting thing and as it relates to private credit, if you think about venture, I’ll start this way. If you think about venture capital funds, you want to pay them a carrier, you want to pay them a part of the upside. So you want to pay them some incentive to generate a high return. You’re in venture capital to generate a really high return and you’re willing to give up some of that upside to allow them to take the risks required to generate that return.
The way we think about private credit is you’re trying to invest to protect your downside. We don’t want to incent a provider to take incremental risk in the credit space. So, we’ve had this discussion with several of our managers just regarding how the incentive fees work and how the alignment of interest works out. And again, back to being a scale investor, it allows you to negotiate terms that align all the motivations of the investor and then the underlying fund as well. So in some cases, it may be possible to get that eliminated so that you’re not paying that profit incentive on a pool of loans like you would in a venture capital fund for example.
Stewart: So Bob, trying to discern best-in-class managers. There’s a little bit of art, a little bit of science there. So can you talk a little bit about how you scrutinize your managers when you’re making those selections?
Bob: Yeah, sure, Stewart. Yeah, and I think you’re right. Art and science, that’s a good way to put it. And for us it always starts with the art part, I guess, it’s the qualitative issues that we’re assessing first and foremost. So we want, I kind of alluded to this earlier, but we want to invest with quality teams, quality people, highest integrity, highest character. And we like to know a team very well. It’s one of the key functions of our investment teams is to get to know partners at the funds we invest with extremely well. So it all starts with a quality team, consistency of the team. We don’t like to see a lot of turnover.
We were looking at a fund, just as a side note maybe to bring this to life, there’s been a lot of private credit funds raised in the last 10 years and several of them are new and they have brought together partners from a bunch of other firms and individually, a very strong track records of these individuals. But you put them together into a firm where they’ve never worked together before and you just don’t know how they’re going to react in a down market. How are they going to get along professionally? How are they going to make investment decisions? They sound like very soft issues, but they’re very meaningful. Partnerships can be very delicate. And understanding the inner workings of those is key to the long-term investment. So, that’s the art part.
Shifting to the science part, we made a decision years ago not to invest in any private credit funds that did not exist before the financial crisis. And that decision was based on the fact that you cannot adequately underwrite credit discipline and work out capabilities unless you’ve been through a stress cycle. And the only way to really do that is to see how a firm performed back in 2008, 2009 time period. So we look a lot at default history. We look at how firms deal with defaults, how they manage through their defaults.
Another just anecdote on that one, I’ll give you an example of two different firms. And this came out at COVID by the way, through the COVID period. We were speaking to one firm and they were talking about how they had a borrower go into default and they had the opportunity to increase their interest rate they were charging on their loan because the company was in default and needed some relief. And so they took the opportunity to raise their fees. Contrast that with another lender who said, “Yeah, we had a borrower go into default.” They were in a liquidity situation. So we asked them, we asked the private equity firm who was backing that company to put more money into the company to make our loans safer. So they didn’t try to gouge him on the fees, they wanted to protect their loan through a difficult period. So two very different approaches there. We’ve taken the approach, and so in diligence, we would look at those kinds of things and our approach has been to take the safety first route as it comes to credit as opposed to the higher returning piece of it.
So we’ll look at things like that. We’ll look at deal structures, see if they can get covenants. We’ll see if they are the lead lender in transactions. We’re big fans of the lead or co-lead lenders because they’re closest to the company, they’re in charge of the documentation process, they’re closer to the private equity owner if it’s a private equity back deal. We’ll look at origination networks just to understand how they’re sourcing deals. We’ll look at the relationships with private equity firms. It ends up, private equity firms don’t want to risk a deal on a lender they don’t know well. And they also want to go through the trenches with their lenders as well because they really know how they’re going to react in difficult situations. So again, back to underwriting the history and how they’ve performed in down cycles.
So all of that comes into play. We do have an operational due diligence team that goes out and make sure all the systems are good at the underlying manager. And then we hire a private investigator to actually do background checks on individuals at the firm, and at the firm, just to validate and verify all the more softer, the art piece we talked about to confirm that as well.
Stewart: That’s a first for me. So, that’s interesting. That’s pretty thorough due diligence. You talked a little bit about the fact that there’s been a number of credit shops that have opened the last 10 years. Different firms have different strategies. How do you determine how to fit these managers together? So, you’re in a similar situation to an insurance company when you’re looking at different manager opportunities. How do I put these together in a way that I get a diversified portfolio that’s going to perform well over time?
Bob: That’s a great question. As an allocator, I guess the first thing I would start with there is we have to figure out what strategy do we want to pursue? Because, like you say, private credit comes in all shapes and sizes. And so we want to figure out: are we investing in private credit to get income or are we investing in it to get some appreciation? Do we want to take more risk in it by investing in mezzanine debt-type funds and structures or do we want to invest in senior loans? Do we want to invest in sponsored versus non-sponsored deals? So there’s all these different flavors that you have to figure out how to put together or where you want to go. I think another way to think about that is where does that allocation come from? You’re making a private credit, is it out of your fixed income portfolio? We’ve seen a lot of investors take it out of their private equity portfolio just because we do private equity backed loans and then some investors have an opportunistic bucket they take it out of, and then how are you going to benchmark it?
So all those things come into play I guess first and foremost on what are your goals, what are your objectives and how do you narrow this huge universe of private credit funds into something that you’re very interested in, that really can solve those objectives you have. But then after that, we are big believers in not over-diversifying private credit. I’ll come back to my venture capital analogy. If you’re investing in venture capital, you want to do a lot of deals, you’re going to get a lot of losses, you’re also going to have some big home runs, but you’re not really sure at the outset. You want to make sure it’s broadly diversified as possible. In private credit, the outcomes are much more narrow. You’re not going to get big return dispersion in the outcome of investing in a private credit fund like you would a venture capital fund.
So we’re not going to over-diversify you. There’s no use to have three or four of the same managers doing the exact same thing. So the way we structure it is we think about the different pieces we want to cover in the market and then try to package something that gets you diversification into different areas of the market. So we may have a lender that lends to companies with $15 to $20 million in EBITDA, smaller businesses. Then we may package that with a lender who does $50 to $75 million in EBITDA. So a little bit bigger. We may get some geographic diversification by adding a European manager. So we think about ways that all of these different funds are additive to the overall experience of the investor and add diversification, which reduces your risk, but also can enhance yield because of some of the things we talked about earlier, negotiating the fees and maybe putting a little bit of leverage on the structure. So all of that comes into play in how we think about combining managers and putting together to create what we think is a really attractive risk-return profile for investors.
Stewart: Can you talk a little bit about liquidity in private credit today? Just a lot of insurance companies have put a lot of money in private credit. Liquidity’s always an issue for these guys. Can you talk just at a high level about how liquidity has been? There’s been a lot of turmoil, a lot of market volatility. What’s the current situation in the liquidity of the private markets today?
Bob: Yeah, that’s another really timely question and it’s something we think a lot about by the way, because I think with the growth of private credit, you’re seeing all kinds of unique structures that are coming out, and investors, they want the illiquidity premium that private credit can generate for them, but they want it in a liquid structure.
Stewart: Of course.
Bob: Yeah, exactly. And it’s a tough thing to manage. So, I’ve always been a little concerned when you combine a more illiquid asset into a liquid structure, you may get some conflicts there in times of stress. So we are big believers on our team and generally on capturing illiquidity premiums. So, we do believe in aligning a patient capital base with the underlying asset, meaning what I’ll term, we would be in a term like five to six years with lockups through that term just to make sure that the underlying managers have time to originate the loans and then exit them.
One thing we like about the private equity backed market for these leveraged loans is that there’s a natural exit to them. Private equity firm’s going to buy a company, they’re going to sell it at some point, maybe three years or maybe seven years. But there is a built-in natural exit that will occur. But I think this market’s going, liquidity’s going to be tougher to come by, you’re not going to get those hold periods on these loans was going to lengthen as M&A markets dry up. But I always try to shine a word of caution on combining illiquid assets and more liquid structures because sometimes it works great until it doesn’t, I’ll put it that way. So you just got to be a little bit careful.
Stewart: So what about customization or bespoke solutions? A lot of times insurance companies have particular constraints and so forth. Are you able to come up with a strategy that has some customization? If somebody has exposure to a particular segment already, can you create custom solutions? Can you talk a little bit about your ability to craft solutions for a client?
Bob: Yeah, absolutely. Something that’s doable and as a matter of fact, we do that in some of our structures. For example, we’ve carved out what we believe to be maybe more volatile or riskier industries from a credit perspective. So things like commodity linked industries or standalone retail or restaurants, they’re historically deemed to be riskier industries from a lending perspective. So, we could talk to our fund managers and say, Hey, we want to carve these out, we don’t want these in our portfolio. You could carve things out based on, or EBITDA limits. I mentioned earlier we have a small market lender and a middle market lender, let’s say, in your portfolio, you could go to the middle market lender and say, Hey, we don’t want you doing any deals under $25 million in EBITDA. You’re preventing them from swerving out of their lanes into the other firm you’ve chosen into their strategy. So there’s a lot of different things you can do and managers are generally very willing, especially if you can set up these separate or customized accounts to talk about different guidelines that the investor wants.
Stewart: You’d mentioned earlier terms of leverage. How often are you using leverage and when you do, how are you using it?
Bob: Yeah. So we have both capital call facility, which basically just allows us to manage cash more efficiently, it’s not a long hold period on that facility. It allows us to consolidate capital calls and things like that to just make it more efficient for the investor. But then we also do use term facility on our funds. You can dial up and down leverage depending on your yield targets, depending on your risk tolerance for taking on that kind of leverage. I do think it’s very important when you’re looking at an underlying fund manager, and it is very important to understand how they use leverage. A total return swap type facilities can be very different than a term facility. So it depends.
But we do believe strongly that modest amounts of leverage do not add a significant incremental risk relative to the yield enhancement. So we will use leverage facilities and we’re fine when underlying managers do as well, but it’s something we talk to them about. Actually, with underlying managers we invest with, none of them are the same. The least risky could be up to say two times levered and the most risky can be at 50% levered. So it just depends on the risk we feel like we’re taking and how much risk it adds to the overall investment.
Stewart: Are there segments in private credit that you think where there are opportunities and is there anything that you’re a little bit more cautious on right now?
Bob: So I’ll start by saying we are big believers in private equity sponsor backed loans. So these, we invest with managers who provide loans to companies that are owned by private equity firms. And the way to think about, as we think about risk-return, I guess I’ll put this in two buckets also. You can stretch for more risk in the underlying asset. For example, invest in mezzanine debt funds, which have a higher yield and a higher return profile maybe than a senior debt fund, and not use a lot of leverage on it. That’s your yield. You’re going to get the yield out of the mezzanine debt fund. We’re bigger believers in taking more safety in the underlying asset, which we believe sponsor backed loans are a little safer, certainly maybe than mezzanine debt. But then using that leverage we just talked about to enhance the yield.
So it’s another way to get to the same place a little bit, but our belief is it’s easier to manage our leverage levels at our fund than to work out of loans at the underlying level. So we’re in the camp of lower underlying asset risk, use a little leverage to enhance yield. And we really like the private equity backing. I think you saw it in COVID. COVID was actually a great test, by the way, for what’s going on right now in terms of market dislocation and inflation and rising rates and expense increases and all that at these companies because firms had to drive more liquidity into their companies, because think back to COVID when it first happened, no one knew what was going to happen and how long this was going to take. And having private equity firms as owners of these businesses, and one, they’re professional business owners. So they’re used to dealing with issues and managing through different cycles.
Secondly, they have deep pockets, they’ve raised a lot of capital and they can put money into these companies to support them in down markets. And that type of, the ability to put that capital into those companies is huge for the senior lenders. And then I mentioned earlier that they have a natural exit to them because a private equity firm’s going to… And no private equity firm wants to go raise their next fund and show a big goose egg on one of their investments. So they’re going to support those companies and all of that accrues to the benefit of the lenders. So we’re big fans of that market, especially where rates were increasing a little bit. So it works against a little bit more, but we can still get a nice little arbitrage on our borrow rate and our lender rate to enhance that yield that we’re getting from these, what we consider relatively safer assets.
Stewart: On these podcasts, I always learn the most. You have taught me very well on this one and I really appreciate you coming on. At the top of the show, you mentioned that you’re from Huntington, West Virginia. I’m from Imperial Missouri, and I don’t know how many people from Huntington, West Virginia end up being the managing director and chair of the investment committee for a firm like 50 South Capital. So I guess I’d ask you this, as you look out today with the history and success that you’ve had, what would you tell your 21-year-old self?
Bob: Wow, that’s a deep one, Stewart, let me… Yeah, as I think back, first of all, I think one, it’s just follow your passion or what you love and become an expert in it. I think make yourself irreplaceable and valuable to the firm you work with, or to yourself really. And then the other thing I find that we have a lot of associates on our team, we do recruit quite a bit out of colleges, it’s the associates that always go the next level. They always exceed the expectations you have set for them. They’re always thinking of the next question that you’re going to ask. Those kind of things are just so valuable to us as a firm. And so maybe that’s two and they’re probably worth not even one. But that’s what I would say.
Stewart: I think it’s great advice. I really do. It’s been great to meet you and I’ve learned a lot and I really appreciate you being on, Bob. So thank you very much.
Bob: Thanks Stewart, I really enjoyed it.
Stewart: I’m glad you were on and thanks for listening. If you have ideas for podcasts, please email me at email@example.com. My name’s Stewart Foley and this is the InsuranceAUM.com podcast.
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