Stewart: Welcome to another edition of the InsuranceAUM.com Podcast. My name is Stewart Foley, I’ll be your host. And today we’re talking about the compelling opportunities in the corporate credit market and we’re joined by Jamie Weinstein, managing director, portfolio manager, and head of corporate special situations at PIMCO. Jamie, thanks for being on.
Jamie: Thanks for having me, Stewart.
Stewart: We’re thrilled to have you and there’s a lot to talk about today, but before we get started, I want to start with the way we start them all. What’s your hometown? What was your first job, and fun fact?
Jamie: So my hometown is… It’s an interesting one. It’s Miami, Florida.
Stewart: Oh, that is an interesting one.
Jamie: It often gets a reaction out of people for sure. My first job actually was working for an accounting firm doing IT-related projects. That was what I did late in high school, and then that led to me actually starting a business at the end of high school doing IT projects for small companies.
Stewart: No kidding. I was flipping burgers at McDonald’s, so you can see obviously I was behind early. And what about fun fact?
Jamie: Fun fact, I guess a surprise to some, is I was a sports radio play-by-play announcer when I was in college.
Stewart: Oh, wow. What any particular sport or-
Jamie: I did a lot of football and particularly basketball.
Stewart: Wow. I used to work at Lake Forest College and there was a young man there that was just outstanding at it and it’s such a talent, what a cool thing to have done. That’s cool.
Jamie: It’s kind of the road not taken for me, career-wise, they might say.
Stewart: There you go. There you go. So before we get going too far, as the head of corporate special situations at PIMCO, can you talk a little bit about what your day-to-day looks like? What markets you’re looking after before we get into the particular questions related to opportunities in the corporate credit market?
Jamie: Geographically it’s a global role. So it’s managing teams and investments in the US, Europe, and a little presence in Asia Pacific. It’s looking at opportunities in the non-investment grade credit universe. So things from leverage loans and high yield bonds that are in the syndicated or tradable markets, to what you might call performing private credit. So originated credit positions in mid-size or upper middle market companies, and then into the universe of stress and distressed credit, as companies may be facing challenges and capital solutions, where you’re providing new money to challenge companies, and potentially companies going through bankruptcy or that kind of transformation.
Stewart: And it’s interesting, I’m getting ready to moderate a CFA New York CIO Roundtable panel, and I did it last year as well, right at a year ago. And at that point a year ago, it was all about “Oh gee, the rate market’s so low, where do I find yield, blah, blah,” and a year later it’s much more concerned about risk management. So that leads me to the question of, how would you compare this cycle versus previous ones, say the Asian crisis, the dot com, European crisis, or the GFC?
Jamie: Each prior cycle is sort of instructive in terms of historical patterns and how things unfold, but history doesn’t repeat itself in any one of these. It might rhyme, but it doesn’t repeat itself as they say. So you look back at prior crises relative to this one. The thing that stands out the most, I wouldn’t call this one a crisis yet, but the current situation is the sharp increase in interest rates is a unique fact pattern. That was not what you saw headed into these other environments.
In those, you typically had relatively higher interest rates and you had a supportive central bank, that ultimately eased significantly to relax financial conditions. Here, some of the pressure is being created by a central bank’s tightening financial conditions in the face of high inflation. So if you roll the clock back and you say, okay, what about the GFC period, the global financial crisis ’08 and ’09, you came into that with live more north of 5% at the time, but it was really driven by a banking crisis, a financial system liquidity problem based on mortgages.
And credit quality mortgages then emanated out into other asset classes and became a global issue. This time around, the problems are not in the banking system. Banks are much better capitalized than they were then. They’re running lower leverage, they run under much stricter regulatory regimes. So you can say that the regulatory changes post-GFC actually worked to a large extent. If you go back to kind of 1999 to 2001 period, where you had the dot com boom and then the crash that came after that, in credit markets, most of the problem was in a lot of high yield bonds that related to telecom, as an example.
So it was relatively concentrated in tech and telecom. It was not a broader sort of systemic issue. You go back to kind of ’89 to ’94 and from a US-centric point of view, the collapse of the savings and loans and a lot of problems in the corporate credit markets, that was related to over-leveraged real estate lending. You were able to get loan-to-value on buildings or development projects in the late ’80s, north of 100% of costs, didn’t make any sense and ultimately it led to a systemic problem in that sector. The segment from late ’70s to early ’80s with super high inflation, and the cracking of that inflation by the Volcker Fed, is probably most analogous to today with a lot of different factors at play. But that’s the one that probably looks more like this one, where you have a slowdown being brought on by central bank activity trying to bring inflation back down.
Stewart: So if we can talk about… We’ve had a very benign default cycle for quite some time. So what are your thoughts on a true default cycle if the fed is not there flooding the market with liquidity?
Jamie: The default numbers have been pegged in and around 1%, but for a little wiggle around COVID, in and around 1% in the non-investment grade credit market, corporate credit markets for several years now. And that’s because, as you said, the taps were open from central banks to a large extent. It was almost impossible to default. You certainly didn’t default for liquidity or maturity problems. There are no maintenance covenants anymore in a lot of corporate credit land. But you were able to go to public markets or private markets depending on the size of your company and access refinancing, even for companies that probably shouldn’t have been able to, they were able to. And in particular, recently, very low interest rates made it very achievable for companies to carry large quantums of debt.
Without that central bank support, without that excess liquidity being pumped back into the system, it’s our view that that default rate does tick up materially from here, but not to an extraordinary level. Historical levels, you might have seen a long-run default rate of around 3%. It’s my view that it ends up somewhere around 5% for the next couple of years and it starts with a lag. It’ll start that material mover starts sometime early to middle 2023, but should persist for at least a couple years.
If I dimension what that means, and if I take US markets as a good proxy for that, you say there’s $3.2 trillion of syndicated loans and high yield bonds and about $1.3 trillion of private credit. Of that, about $1 trillion is performing generally first lean or second lean acquisition financing, so let’s put that in this category. So let’s say $4.2 trillion in aggregate, if I use a 5% default rate for two years, that’s 10% cumulative. That would say there’s $420 billion of capital structures that need to go through some kind of restructuring event or transformation over the next few years.
Stewart: And that is a significant number, which leads me to: insurance companies are major players in corporate credit markets. How and why should insurance companies be looking at opportunities in the corporate credit markets today?
Jamie: I’d say a couple of different reasons that would be the case. One is the fact that there’s relatively little capital formed, relative to the size of what we just dimensioned as an illustration. There’s relatively little capital today to invest in those situations and solve those problems. So on our math, the amount of opportunistic flexible capital in that private credit universe, remember I said there was about $1.3 trillion of private credit, of which $1 trillion was performing acquisition financing. The other $300 billion is flexible. Not all of that is intended for stress and distress, but that’s not enough necessarily to solve all of the issues.
So insurance companies who have a clean balance sheet, who have the flexibility to take advantage of that opportunity, there is a need for some of that capital and the pricing on that capital, the risk/reward has changed, I think materially for the better in their favor. Second, I think insurance companies have the ability to take on illiquid portfolios or illiquid positions, and I think that’s a huge advantage.
There was not a big liquidity premium being paid while money was free, in terms of what you got as additional compensation for taking that on. But as cash becomes more precious, as central banks are less accommodative, we would expect that liquidity premium to widen again, and again, that should be a further tailwind for the return potential for investors that can take advantage of it.
Stewart: And that makes sense to me. Kind of shifting gears just a little bit, we’ve seen spread widening and risk aversion in the public markets, but not as big of a reaction in the private markets. It seems as though that dynamic is changing as we start to see some repricing. Can you walk our listeners through what has happened on the back of these headwinds, notably the rate hiking cycle that you mentioned that the Fed has been on in the face of significant inflation?
Jamie: I’ll talk about it from two dimensions. One on the capital formation and capital allocation side, and then one kind of at the front lines for the companies who are facing these issues. So from the capital formation side, there had been tremendous inflows into various forms of private credit, both from institutional investors and from the retail and high-net-worth channel. In the latter case, you had some open-ended vehicles that were raising significant sums of capital, and they were doing it in a way where they were promising investors a certain yield, immediately they have to get invested. So as soon as that money comes into those vehicles, they’re making new loans. And you saw some of those, whether they were open-ended funds or they’re BDCs (business development companies) in the US context, they were deploying very large tickets into new deals. So the size of deals that could get done in the private markets grew.
The number of players who could write $200, $300, $500 million checks in a single name grew. And so private markets that used to be confined several years ago to doing deals, $500, $600 million tops, suddenly you were seeing them do deals, $1 billion, $2 billion, $3 billion in private markets with a handful of players in like a club format at the very largest end. And with a single shop at the $1 billion size, potentially. That capital formation vehicle on the retail high net worth side has stalled out significantly.
Likewise, on the institutional side, you had a lot of investors creating private credit allocations as part of their overall asset allocation model and systematically deploying capital into that. You saw big commitments in 2019, 2020, 2021. A lot of that capital got deployed and now those institutional investors are facing portfolios with the denominator effect, which I’m sure you’ve talked about on some of your prior podcasts.
And in that case, as those flows slow down and as the retail high net worth flows slow down, there’s just less liquidity now in the hands of managers to make new loans. So those large ticket sizes are a bit in reverse and you’re seeing very few people willing to do more than a $100 to $200 million in a single name. And so if you’re a borrower trying to borrow $500 million to $1 billion now, it’s dramatically harder than it was six to nine months ago, so the early part of this year.
On the company side, what are they facing? It’s a pretty wild environment for them with the combination of higher inflation, slower growth, elevated geopolitical uncertainty, war situation coming out of that in continental Europe, supply chain issues that are not yet fully resolved. All of these sorts of disruptions in businesses before you face higher interest rates eating away at your cash flow.
Management teams have never seen this combination of factors before. Go back to what we were talking about earlier about the different kind of market cycles that we’ve been through. None of the C-suite of levered companies today were in those seats in the late ’70s, early ’80s. They were unlikely to have been in those seats in the S&L crisis. Maybe some of them were there in ’01, a handful more in the GFC, but none of those environments looked like this.
So they’re facing a set of factors they’d never seen before. The likelihood of them making a mistake is elevated. And we’ve seen some of that already across the landscape. We’ve seen some companies with idiosyncratic issues that were created by a misstep or a combination of missteps on one or more of these factors, and that brings them to the table potentially where they need additional capital in an environment where it’s a lot less favorable to source it.
Stewart: And we talked about some compelling opportunities. Can you talk about what the main drivers are of the opportunity set and how managers like PIMCO are able to take advantage of this?
Jamie: I think a couple things are drivers. I think one, if you look at where I would expect the early issues to happen is across things that face consumers. There’s been a lot of discussion of consumers having strong balance sheets and they do relative to prior economic periods. There was a significant tailwind to consumer credit in the COVID period, but that’s in reverse now. Those consumer balance sheets are normalizing the jobs picture while very robust, maybe too robust for the federal reserve’s liking, is slowing.
And as that continues, we would expect more pressure on consumer-facing businesses. You had some businesses who assumed that the buying patterns from the COVID period were the new normal. And I think as everybody kind of got back to living their lives, you showed like it’s not different this time. People are going back to their pre-COVID routines and lifestyles.
And so some of those ships have already happened. You’ve seen that in some of these technology-related businesses that have seen big reversals and you’re starting to see it in some retail and e-commerce businesses as well. On the other side of that, obviously, the supply chain issues that were heavily talked about impacted a lot of companies along the way. They’re not fully over yet in the sense that many companies burned a lot of cash trying to resolve those issues, just trying to survive. Things like spending a lot of money on air freight or having significant stock-outs in their warehouses, or stores, or things like that.
Those things that burn cash reduce their flexibility now to face a slowing economic environment. So we’re starting to see early signs of that as well. Lastly, I’ll touch on one area that we think is pretty interesting, which is around growth companies who, a lot of which are technology-focused or technology-adjacent, who achieved really high valuations in raising equity capital over the last few years, some stratospheric valuations.
In fact, that market has been thrown into reverse. The venture capital market, the growth equity market, valuations are coming down, flow of capital of companies is way down. They’re sort of deal activity. And for the companies that raise money at high values and now they need to come back and raise more, because they’re not yet profitable, they’re kind of stuck where they have this high face valuation, they don’t want to reprice it lower and now what do they do? Do they take a significant down round? Or do they do some kind of highly structured financing to avoid taking the mark? I think we’re in the period right now where a lot of people don’t want to take the mark.
Stewart: Yeah, that makes sense. And you used a term earlier in the podcast, you used this term ‘flexible capital’. I’m not as familiar, I don’t know that term. Can you talk about what flexible capital is and what kind of opportunities that it creates?
Jamie: It really means the ability for the fund manager or investor to create a solution that is fit for purpose for the problem that a company or borrower is facing. It could be new super senior money at the top of a capital structure that’s very well downside protected and is at maybe a lower yield, but is significantly better risk reward. It could be in the middle of a capital structure that money comes in, kind of wedging in between other layers of the debt structure. It could be something that looks more like a preferred equity position or hybrid security.
It might have some equity-like features to it from an upside generation perspective, but still having the downside protection of something that looks structured like debt. It’s really giving the manager the flexibility to come into any situation with a clean sheet of paper and design the solution that’s the best fit for the company, and the best fit for that investor’s portfolio.
Stewart: That’s really helpful and I think most people, and me included, know PIMCO and associate you with a high-quality investment grade presence. But you’ve deployed a lot of money in private corporate transactions. Can you provide some background on how PIMCO has developed that presence and why borrowers are coming to you today?
Jamie: The PIMCO corporate credit platform broadly defined as you mentioned, is a huge starting advantage for us. So we manage over $500 billion of credit assets across investment grade and non-investment grade kind of liquid or tradable assets, plus our activities in the private segment. And in private corporates, for example, we’ve done over $10 billion of transactions in the last dozen years or so. And you might say, why do people come to us? What’s the edge that PIMCO has?
First of all, I think we have a reputation as somebody that can grow with companies over time. So lots of companies who borrow this kind of flexible or private capital, they have a vision that either their situation is going to get better, they’re going to grow significantly, their capital structure is going to normalize and they’re going to want to tap the broader public or syndicated markets on the back end as they grow into that level.
They believe that having a relationship with PIMCO will help them do that, because we could potentially be an anchor ticket in that kind of financing when it comes to the broader syndicated market. So I think that’s one aspect of why people might choose to work with us. Another is just the scale of our platform. We have a significant base of capital, a number of different funds that can invest in some of these transactions. And so we have scale on our own and I think this is an important factor for us and for them.
We want to be able to invest in situations where we can control our own destiny and create the outcome that we’re seeking without being dependent on other credit investors. Likewise, for the borrowers, they want to go somewhere where they say, “If I negotiate a deal with you, you can deliver.” This isn’t just the beginning of a broad syndication, this is I can get this anchor thing done, maybe the entire thing done with PIMCO, and then I have certainty of execution to fulfill my need or solve my challenge.
And then lastly, just the depth of our resources and ability to understand companies, understand risks and underwrite them effectively. We have a nearly 70-person global credit research team who covers industry verticals up and down the capital structure. We marry that with generalist resources who do some of these more private and structured transactions.
So you bring the best of both worlds, that industry depth and the transactional expertise coming together, plus all of the other asset classes that PIMCO is deep in across things like mortgages, specialty finance, energy and commodities, interest rates, all of those things that filter into the analysis you would put together to understand the situation of a borrower and be able to price that risk effectively. I think that gives us a real edge.
Stewart: One of the things I love about doing podcasts, particularly with subject matter experts like you, is that I get to learn so much. And so I really appreciate you walking me through these opportunities in the corporate credit market and, really, better understanding what all of the facets that PIMCO is involved in, because I just honestly didn’t know some of the things that you just mentioned.
So part of my career involves teaching. I was a professor for a number of years and I’ve got a soft spot in my heart for young people who are early in their career. And I often ask our guests, if you look back on the financial services landscape today, you look out and you look at the opportunities and challenges that exist. What advice would you give your 21-year-old self today as you look out at the opportunity set?
Jamie: It’s a great question, because I was having a conversation recently with the son of a friend of mine who is 21, who is graduating from college in this upcoming spring, and is thinking about a lot of the things you just mentioned. I think the number one thing for any of them as they think about their first job is to focus on the learning and focus on the mentorship. It almost matters more who you work for and what you can learn from them as an individual, rather than the organization that you go to or the exact job that you do. I feel like that was transformative for me in the early part of my career. I still talk to my first boss, he’s still a mentor to me all these years later.
Stewart: That’s so cool.
Jamie: That’s one. And then two, I would say you don’t have to know where you end up or where you want to end up. People get very fixated on the exact tracking of where things go. I didn’t start my career in corporate credit. I even went back to graduate school after starting work, and I didn’t write my essays for that experience about corporate credit, or special situations then either. So if you’re smart and flexible and you’re thinking about different ways of doing things, you’re learning different things, you’re open to new ideas, opportunities will come your way, if you’re well-prepared kind of intellectually and emotionally for them. And I think a lot of that comes from the growth that can happen in those early years, more so than which deal you worked on, or which trade you developed the analysis for or whatnot.
Stewart: Great advice. I love that advice. Jamie Weinstein, head of Corporate Special Situations at PIMCO. Jamie, thanks for being on and thanks for the education.
Jamie: Thank you.
Stewart: Thanks for listening. My name is Stewart Foley. If you have ideas for a podcast, please shoot me a note at firstname.lastname@example.org. Thanks for listening. This is the InsuranceAUM.com Podcast.