Private Credit Beyond the Headlines: What Insurance Investors Need to Know

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Stewart: Hey, welcome back to The Home of the World's Smartest Money. This is the InsuranceAUM podcast. My name's Stewart Foley. I'll be your host, and I'm really glad that you're here with us today. You would have to be living under a rock in this industry to not have seen headlines about private credit. And if you looked at those headlines, you would think that private credit is somehow under siege. Stories go on and on about borrowers, questions about valuations and liquidity, software exposure, AI disruption, on and on and on, business development company (BDC) redemptions. But here's the question I've been wrestling with, which is, are those headlines describing private credit or are they describing one particular corner of private credit and private assets? And I've recently read a paper from Principal, and I came away with a different conclusion, which is, the headlines are real, but they're not telling the whole story.

And today's episode is entitled Private Credit Beyond the Headlines: What Insurance Investors Need to Know, which is right down the center of the fairway for our audience, Tim. I'm joined today by Tim Warrick, CFA, Managing Director and Head of Alternative Credit at Principal Asset Management. Tim, welcome to the show. How are you? You're a repeat guest on top of it, so double welcome.

Tim: Yeah, it's great to be back with you, Stewart. And yeah, just great to be here. Really looking forward to our conversation today and appreciate it.

Stewart: Yeah, my pleasure. And so for those who may not know, just a little bit about Tim's background, he is going to be professor for a day here, so it's good to have some background. Tim leads middle market direct lending platform at Principal and has spent his career investing across both public and private credit markets. That breadth of experience gives him a unique perspective on what's actually happening today. And we always start them off the same way, which is where did you grow up? Because I've forgotten. And the new question is, what is something that your colleagues would be surprised to learn about you?

Tim: Well, I grew up in Iowa most of my life. I was born in New Mexico, though, so started my life there. And then most of my colleagues would be surprised probably that I grew up in a family that my dad was a teacher and guidance counselor. My mom was a therapist, but my dad also raised purebred pigs, so I got to grow up realizing physical labor much of my life and then realized college was the right path and finance was even the best path within my college experience as well.

Stewart: Yeah, raising pigs in Iowa is no small feat. That is real work. And it's interesting, that's great stuff. I think people need to hear, particularly people like me that came from the middle of nowhere in Missouri, that you can do that, start there, and end up with a very successful career in finance as you have. So I think that's an inspirational story, just to be honest. But let's start about where. Yeah, my pleasure. I mean, I'm sincere. I mean, I don't know about you, but nobody that we knew, my family, nobody we knew, knew anything about finance. I mean zero. We knew people who worked at the bank, like the tellers and whatever, but we didn't know. This was in the day, ATMs were introduced. We used to just go physically to the bank and we would see the tellers and whatever, but that's as close as I ever got to finance.

And I do think it's inspirational. But I'd like to talk a little bit about the issue that investors are facing today and where this really comes from, and I know you know this, but chief investment officers, I mean, they have a career and they want to keep their job and no doubt about that. And they have investment committees and boards of directors that read, and media outlets love to get the headlines. They love to fan the flames. But talk a little bit about what the headlines say and what the real story is in today's private credit market.

Tim: Yeah, the headlines are definitely quite dramatic at times and kind of one-sided, I would say, not really telling the whole story by any means. Very oriented towards the larger transactions, the BDC headlines, the structural issues with the BDCs, the liquidity provisions, the promise of liquidity, but not the guarantee of liquidity in BDCs as compared to interval funds or other vehicles that provide some form of liquidity. So you've got credit events as well that have been highlighted all the way back to the cockroach discussions and things like that, that have really been large transactions, oftentimes broadly syndicated loans, not even really private credit, more on the syndicated side. And then those large transactions that were being done, especially in 2021 into 2022 in a low rate environment. A lot of it was software during that time. A lot of these BDCs and large managers focused on deploying capital as rapidly as possible.

So really, the evolution of the industry, the evolution of private credit, has caught up with itself a little bit. Some of these headlines were more or less assured at some point. Some of the events are true credit concerns or issues that investors should be looking at and discerning. And I think that's one of the positive things is: not all credit is made equal, not all private credit is made equal. And these headlines have really allowed investors to step back, discuss with their boards, with their committees, whatever the case, their own internal teams, where the value is, where the persistent value will be, where the value is historically, and how have things changed so dramatically now that we've got multiple segments of private credit. We've got headlines that are distorting the view of what private credit really is. So I think there's a lot of positives that can come from this: part of it, education, part of it just focusing in where the value's going to be longer term as well.

Stewart: That's super helpful, and it's going to get me up on my soapbox for a minute. It has been discussed on this podcast that there were plenty of investors in BDCs that should not have been. I mean, the “bozo no-no” is you expect to be getting an illiquidity premium in private assets and then expecting liquidity. Seems to me to just be a fundamental misunderstanding of what it is that you're buying here. We're not trading these assets. These are not liquid. And it just seems to me that some of that stuff was people buying it that maybe that wasn't the right fit. You mentioned that not all private credit is created equal. And in reading your paper, it certainly stood out to me. And you've used some terminology that I'd love to unpack, syndication versus not. But there's lower middle market, core middle market, upper middle market, large cap direct lending, and everybody seems to have a slightly different definition of what specifically that means. So can you talk a little bit about the distinction and why it's important to insurance investors today?

Tim: Yeah, insurance investors have the benefit, oftentimes, a long investment horizon, a very discernible and distinguished investment horizon anyway. So the ability to take that illiquidity premium and benefit from that, I call it an inefficiency premium because the market's much less efficient, especially as we evaluate the core and lower middle market that I'll define here in a moment. But that's where, if you look at the broad ecosystem, borrowers and private equity sponsors want to have that certainty that pension funds, that insurance companies can bring to the equation, with that capital that's more permanent, that supports the business, that supports the investment thesis, the growth strategy and such. They don't want the uncertainty that comes from the public markets where there's systemic risk that ebbs and flows. They don't want the volatility of liquidity that can hit the public markets and create systemic risk. And they don't necessarily want banks either that are less flexible.

So they want what has been driving performance for private credit and middle market direct lending for decades now. They want that certainty, that ecosystem that's $400 billion of dry powder private credit and $2 trillion of dry powder on private equity. And that's what insurance company investors can deliver. And that's where the focus should be. Again, from our perspective, that's where the persistent value is, lower and core middle market. We define the lower middle market as companies with $5 to $15 million in EBITDA. That's roughly up to $100 million in revenue. So still diversified businesses, typically service-oriented businesses. Core middle market, $15 to $50 million in EBITDA. So getting up there to $500 million in revenue roughly, so quite diversified businesses. Upper middle market we would say is $50 to $100 million in EBITDA, so up to $1 billion in revenue. That's where you're competing.

The lenders that focus there are competing directly with a broadly syndicated loan market. So they have to compete on terms from leverage to covenant or covenant-lite structures and pricing. And then you get into the large cap direct lending that you talked about that's even beyond $1 billion dollars in revenue or beyond $500 million in debt facility size. So as you move upmarket, the benefit to those lenders is they were able to deploy capital much more rapidly. The marketing machines were working, whether BDCs or large funds. And in order to keep up with that machine, they chose, and oftentimes chose anyway, to move upmarket to deploy capital more rapidly into larger transactions. We think there's much less efficiency down in the lower middle market, thousands of transactions to choose from that provide diversification for insurance investors. But you can still harvest, as an insurance investor, or any investor, harvest that illiquidity premium, the inefficiency premium, better terms such as real meaningful maintenance covenants, lower leverage, significantly lower leverage, so better fixed charge coverage.

Oftentimes companies are growing at a nicer rate, so de-levering more quickly through organic growth and add-on activity. So there's all kinds of benefits to that. The structure with leverage and covenants, pricing and other aspects, just the greater diversification as well, that provides those benefits to investors.

Stewart: Yeah, it's interesting that as insurance investors, I'm convinced that if you ask a group of CIOs, would you rather have top quartile performance or would you rather have no other than temporary impairment (OTTI) or no default discussions or distress discussions at your investment committee? So they're focused on the downside protection. But as I read your paper, and it really is more about identifying problems early, right? And what I would call that is portfolio management. It's like we all focus on how good is your underwriting. It's like, yeah, okay. But it's more than that. It's portfolio management of monitoring what you have to try to identify potential problems and get in front of them. When you're looking around today, what indicators are you watching most closely?

Tim: I would step back a little bit and just say, it's really important to have portfolio construction be part of the process too. Many firms are very bottom-up oriented or almost solely bottom up, so they're really looking at deal by deal and whatever gets originated turns into your client portfolio. We take a more broad perspective or holistic perspective where we think it's really important to consider the macro environment, but long-term, assume there's going to be recessions, assume there's going to be cyclical downturns. So build a portfolio, constructing the industries that are going to be more resilient through that cycle, focusing on those industries that can have that demand that's consistent, revenues that are consistent, margins and cash flow that are consistent, and that are benefiting from secular trends across the U.S. economy that are going to continue to drive growth and enhance productivity through time. So the nice thing is private equity for the most part, where we're focused on middle market direct lending.

Investors, especially insurance investors, can get that additional diversification to get that benefit of those resilient industries that they aren't necessarily getting in the public markets or broadly syndicated loan (BSL) market. Get the upward secular trends that are going to support growth and de-levering and strong capital structures and borrower performance. And then couple it from a bottom-up perspective to put the right structure. So what we're really focused on and what we've been able to achieve and what's kind of going on in the market is lower leverage. Leverage levels are coming down in this higher for longer rate environment, which has been really good and constructive across all segments of middle market direct lending. So this year we're seeing leverage levels below any different periods we've seen over the last five years especially. And you see that coming down across all the different segments. And notably, in the lower and core middle market, we've got leverage levels that are 1.5 times lower than what's in the upper middle market.

So really important to put the right structures around these transactions. Moody's RiskCalc is a tool that we utilize. And one of the interesting aspects there is the size of the company is a very small predictor of the performance and that default experience that investors want to avoid. So when you're focused on capital preservation, the main considerations for default experience have been leverage, overall leverage level and the debt service level as well. So you take those together. And Moody's RiskCalc, that was about 40% of the factor that's being considered there. So again, we're still looking for those companies that are going to be persistent through the cycle, resilient through the cycle, maintain recurring and reoccurring revenues and cash flows, very service-oriented businesses that are the businesses that drive the U.S. economy and that you and I use every day, whether it be early childhood education, collision repair, repair services, different testing services that are required for regulation, things like that. We're going to provide that really steady outcome, steady performance over time.

Stewart: It does take a lot of rolling up sleeves to look at that many deals though. I mean, the scale of Principal Alternative Credit, I believe, helps you in that regard, I would think. Because if it's Stew's excellent private credit shop, you need resources and human capital to look at all those deals, I would assume. I mean, talk to me about just that. I mean, just deal flow and the team itself.

Tim: Yeah, and it's really important. Investors should always look at how their manager is aligned with their outcomes. So the nice thing here at Principal Alternative Credit, we are investing off of Principal's balance sheet, a significant allocation, so significant allocation in every single loan. So Principal has really supported the growth and the build-out and the development of the team over many, many years now, and focused on making sure we are what we believe best in class regarding resources, process, tools, systems, and such. And so right now today, we're over 40 dedicated professionals on the team with 9 originators focused on both sponsored and non-sponsored origination. So looking at a broad funnel of deal flow, and then over right around 20 underwriters plus then dedicated other professionals, attorneys, and back office and such. So it is a really rigorous process from the origination and underwriting upfront considering both sponsored and non-sponsored transactions.

But importantly, like you were highlighting a moment ago, also through the portfolio management process, which we have true meaningful covenants in every transaction. Over 80% of our debt covenants require a ratchet or a step down on the debt-to-EBITDA test so the covenants actually tighten through time. All the things that our investors are looking for when they want that focus on capital preservation, when they can be assured that we're going to be at the table early if a company isn't performing according to the original thesis, rather than covenant-lite structures, which are going to get to the table effectively right at the time of there's a payment default, which your remedies are pretty limited at that point.

Stewart: I do think that sometimes there's the incorrect perception that investing with an insurance company-owned asset manager means the parent is going to get better bonds than I'm going to get. And you and I both know that there are lots and lots of rules that make sure that that's not the case. So I just think it's always worth mentioning that, as you mentioned, you're investing alongside, you're in effect putting your money where your mouth is, which I would think would give you some comfort. So I think, believe it or not, especially if you listen to this podcast all the time, there are a number of insurers that have not made a private credit allocation. And some of them, their first bite is pretty big. So it's not only the small folks who have not made a foray in here, but some of the larger players as well.

And you could see how somebody would say, "Wow, private credit's had a great run. Spreads have compressed. I guess we missed it." When you hear that or if you heard that, what would you say to it?

Tim: Yeah, I think we're just at the early stages still. This is a transition that will continue to occur. Evolution really has created these different segments within private credit. I think that's one of the misconceptions out there that private credit is all equal beta spread product. It's definitely not; you've got that large cap and upper middle market that is getting more homogenous. I would argue more beta-like directly competing with BSL. Still some value there, definitely more exposure to those industries benefiting from secular trends and such. But as you go down to core and lower middle market, there's lots of value. I just was noting the other day, if you look at the broadly syndicated loan market, I think 23% of the standard index, over 20% is in technology and software. And so you look at the distortion of what's driving the yields there. If you look at true double B- and single B+, the yields are pretty compressed across most industries other than those select few like technology and software.

And here as we look at core and lower middle market, the spread premiums we're still achieving and what are being achieved in the market are at least a couple hundred basis points above what you're seeing in the BSL market. And oftentimes our range, even today, we're seeing spreads at 500 basis points to 650 basis points, averaging nearly 10% coupons in this Secured Overnight Financing Rate (SOFR) environment. So there's all kinds of value there; and then truly to have the relationship lending with covenants and all of the deals, ability to maintain and monitor and engage with the sponsor, with the borrower, monthly reporting typically, quarterly compliance certifications, that is a much closer relationship, which is good from a lender perspective to be able to have the right remedies and ensure the borrower and the sponsor stay in the course that they plotted out according to the original investment thesis, which helps de-risk the business, de-lever the business and all of that.

So there's exceptional value, exceptional diversification, we believe, in the market today. And that has been proven out for more than two decades. We see that value and that still being persistent, especially in the lower and core middle market.

Stewart: Yeah, the insurance industry was in private credit when private credit wasn't cool.

Tim: Right. Yeah.

Stewart: They knew what it was.

Tim: It’s been around for a long time. You're right, Stewart.

Stewart: Yeah, you've been a major player in that world for a long, long time. So one of the things I found fascinating in your work is the observation that portfolio construction really begins before you ever originate a loan. And in a way that seems backward to me. Can you help me understand, not just me, can you help the audience understand what you mean when you say that?

Tim: Yeah, and I've had the fortune to start my career in private credit, spend a number of years in public credit, and then focus on private credit as we see the opportunities in middle market direct lending especially. And so in public credit, like you said, it seems backwards because you can reposition, sell, buy, take advantage of dislocations in the market, and such. In private credit, you don't want to count on that. Definitely there's different managers, different lenders out there trying to create more liquidity in the market, which I think could be a path that investors want to be very cognizant of because of that development of liquidity effectively makes it more like the public market, makes it greater accessibility to passive investors and such that can bid down the risk premiums. That can also create volatility and risk that you may not want, that risk of volatility.

But what we're doing is we're saying, "Hey, we're not planning on trading this. We're going to be able to actively manage it through the covenants and relationship we have with the borrower and the sponsor. But we want to make sure we're starting with, from a top-down perspective, a really resilient portfolio that's going to be a good performer through any cycle. Not only do we do downside testing on every single borrower and every loan to ensure it can withstand the cycle and withstand idiosyncratic events. We're doing that at the overall portfolio construct level. So by removing or eliminating certain industries that are going to be more pro-cyclical, have more operating leverage, more CapEx intensity, and focusing more on the industries that are more free cash flow-oriented, that have resilient demand, both reoccurring and recurring demand, we believe we can create that top-down portfolio that should reduce default expectations compared to the broader middle market by half, roughly.

And then bottom up, you consider the lower levered transactions with covenants that are meaningful and the ability for these companies to grow and de-lever, de-risk through time. You've got a nice complement of top-down and bottom-up in your portfolio construction concept. And to us, it's just essential to start there with that top-down perspective so our originators know where to focus their origination efforts, what sponsors to work with, what non-sponsored sources to work through, and develop that portfolio that's going to be resilient. And we expect to perform through cycles, good times and poor times.

Stewart: Yeah. Let's finish by, we sometimes ask our guests, Tim, to dust off the crystal ball, and this is one of those moments. If you look out, call it two years, what do you think this market looks like? And what do you think that folks would say about this particular period with the benefit of hindsight?

Tim: Yeah, there's going to be continued evolution. There's no doubt. As you highlighted, many investors around the world and here in the U.S. are beginning their allocation. So at early stages, that includes insurance investors as well as other institutions. And the development of the wealth channels will be after this pause because of some of the BDC uncertainty and incongruent expectations between investors and what managers have developed. I think that education, that discernment will be good. There'll be greater clarification between the different segments of middle market direct lending and private credit. So that will be helpful as investors become more educated. I do think there's going to be probably the development of more liquidity in the private market, and I think investors need to be wary of that. If you're an insurance investor, why do you want exposure to, as you were highlighting earlier in the conversation, why do you want exposure through a semi-liquid vehicle?

That can be very appropriate for some clients. By the way, this asset class kicks off regular liquidity given it only has a three-year average life and pays down at 20% to 35% a year, so you can get that natural liquidity, which is great in a portfolio construction and diversification benefit. But you shouldn't want to pay for that liquidity. If you're an insurance investor especially, you should be able to harvest the full premium of the inefficiency, the market, the illiquidity. So be cognizant as these liquid markets develop, not necessarily secondary limited partner (LP) interest and continuation vehicles, but just secondary trading in the loans themselves. That's probably where it's going to be much more beta-like. Continue to focus where the resilient persistent value will be. There's definitely going to continue to be a lot of demand. Borrowers and sponsors all around the U.S., the baby boomer generation that developed and built so many companies that are middle market companies.

There's 200,000 middle market companies in the U.S. Many of them are lower middle market and core middle market. So those opportunities will continue to be present and grow most likely. We're seeing about a thousand deals a year that we're considering in lower and core middle market, and we're selecting very few of those deals, about 3% of those deals. But there's plenty to choose from, plenty of diversification, plenty of opportunity for those investors, especially insurance investors that want to get the benefit of diversification, the better credit structures, the better pricing and yield and income by focusing in where that value will be through time, where the value was historically, and let other segments of the market move on to the wealth side and other things as well. So we think that evolution will just continue. It'll be paused here. The education will become more clear and investors will be better for it.

The market will continue to grow for private credit globally and here in the U.S., and borrowers and sponsors will benefit from that. And overall, the U.S. economy and the economies around the world should benefit through that additional proliferation of capital being provided to those underlying companies.

Stewart: Yeah, that's a really good point. And I've said this out loud and I'm not sure, I don't have a speck of data to back it up, but the insurance industry has funded a lot of economic growth where banks used to be that lender, but no more. And so it's certainly a great point and a great education on private credit today. And I really appreciate it, Tim. I've got a couple of fun ones for you on the way out the door. One is you've had the benefit of experience in this market for a long time. What characteristics are you looking for when you're adding to members of your team there at Principal?

Tim: Yeah, a very inquisitive nature. We talk about our culture and it is our primary factor we're very focused on here at Principal Alternative Credit. That is a positive persistence. So we know there's going to be uncertainties. We know we have to continue to compete and be better every day. We take advantage of those opportunities. So, an inquisitive nature, constructive team members that can challenge one another, but be focused on team and be focused on our investors. So that's what we're looking for. We don't want the same person. We don't want the same all types of people. We want all the great backgrounds and experiences that our team members have. Our team members have experience from 16 different direct lending firms, historically, and we’ve been able to hand select each of these individuals to come in and contribute very positively to our team, to our decision processes, and just to our ultimate performance. So we're really excited to continue to grow, continue to grow alongside our investors.

Stewart: That's awesome. All right, last one. This is a new one, Tim. This is new since last time. This is the second time we've asked this, maybe the third. So describe your best real or fantasy dinner.

Tim: Wow.

Stewart: How about that? This is why I get the big bucks, off stuff like this.

Tim: This is really out there.

Stewart: This is the one.

Tim: I'm thinking about this every day, but I'm pretty boring. I typically eat at my desk, so I'm not thinking about it heading into lunch later today. But no, I think we've got a great steakhouse. We're known for great steak and pork here in the central part of the U.S. here in the Midwest and Iowa where I'm based. So I still think it's, and a steakhouse in this building, a big tomahawk steak. We have one down there, I think it's 46 ounces with bone. I'm not sure I can really eat the whole thing.

Stewart: There you go.

Tim: But I still think that's probably the best dinner I can envision with all the complimentary sides that go along with that and just enjoying it with friends or family or both.

Stewart: That's what I was going to ask you! Who's coming with you?

Tim: Yeah. Well, I've been down there with clients. We've had great dinners. I think I would go with friends, family. Some of those are clients that are friends nowadays, so it's all great people to have around me. Yeah, so I think it'd be a just great conversation. That's part of the great meal is having great people around you.

Stewart: Absolutely. Thanks so much for being on. I really appreciate it. Learned a lot today, and it's great to get to know you a little bit better too, Tim. So thanks so much.

Tim: Yeah, thanks, Stewart. I really appreciate it.

Stewart: Our pleasure. We've been joined today by Tim Warrick, CFA, Managing Director and Head of Alternative Credit at Principal Asset Management. If you like what we do, please rate us, review us wherever you listen to your favorite shows. You can also watch this podcast on YouTube at the InsuranceAUM Community. My name's Stewart Foley. I've been your host. Thanks for joining us at the Home of the World's Smartest Money, the InsuranceAUM podcast.

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