Stewart: Insurance companies are buying private assets like never before, and asset-backed lending is one of those areas. We’re joined today by Connell Haston, partner and head of the Insurance Services Platform at Victory Park Capital. Connell, welcome.

Connell: Thanks, Stew. I’m really happy to be here.

Stewart: It’s great to have you. Before we go any further, let’s start off with our first three questions. Connell, hometown; first job of any kind; fun fact.

Connell: Okay, here we go. Hometown: born in Wilmette, Illinois. Raised in St. Louis, Missouri. Let’s go with St. Louis, Missouri.

Stewart: All right.

Connell: First job. In my first summer of high school, I worked on the assembly line at St. Louis-based manufacturing company that basically made specialized tubes for chemical companies.

Stewart: I love it. All right. What about a fun fact?

Connell: I lived in Seoul, Korea, in Jakarta, Indonesia, for three years of my life when I was younger.

Stewart: There you go. That’s a good one, that’s a good one. All right, so here’s the deal. When we first met, and we have some mutual friends in Chicago who are also in the industry, I was not familiar with Victory Park Capital. So before we go any further, maybe some of our listeners aren’t familiar, as well. Can you give me the high points of Victory Park Capital?

Connell: Sure. So Victory Park Capital, we’re an investment management firm founded in 2007 by Richard Levy and Brendan Carroll, with the thesis of investing where banks do not. And so since inception, we invested approximately eight billion or so and our primary strategy is in the private credit space, with an emphasis on asset-backed lending. I joined Victory Park in 2018, and as you mentioned, co-founded our insurance services platform. So in addition to my investing duties, I also make sure that our insurance company investor base can access our private credit strategies in a way that best suits their needs.

Connell: So, this can be through our co-mingled funds, or through a separate account, or we can also invest directly on the insurance company’s balance sheet, governed by an IMA, which stands for Investment Management Agreement.

Stewart: And so, I have a weird background, and I think versus kind of some other folks in your space, your background’s a little unusual as well, and that you came out of the insurance side, right?

Connell: Yeah. I did not plan to get into the insurance space.

Stewart: No one does Connell. None of us did.

Connell: But I’ll tell you what, I’m genuinely glad it happened this way.

Stewart: Yeah, no, me too. Me too. Absolutely.

Connell: It’s a great group of people. I started in banking trying to follow a prescribed career path. And after banking, I worked as a portfolio manager at a large investment manager where I first managed real estate debt. So senior mortgages and mezzanine loans, and then managed private credit portfolios on behalf of insurance companies. So this is where I like to say, I met insurance, meaning I learned the language, memorized a few states’ statutes, and became familiar with the rules and regulations when investing out of an insurance general account. Then after the investment management firm, I worked for mid-sized life and annuity provider. And here is where I was tasked to build the internal investment management team. So what we did was we outsourced our publics and then internally ran our private credit portfolio, which was focused on real estate mortgage investments, private loans, and structured products. And this was all out of our general account.

So at some point during this journey, I really fell in love with investing out of insurance vehicles, specifically from a life and annuity perspective, which is where I sat. I appreciated how an investor can really take a long-term investment view and take some illiquidity premiums along the way, given that the cash flow profile of its liabilities offers you to do so. And one investment class that I came across was an asset-backed loan strategy, which, as I mentioned, is our main credit strategy and a main reason why I thought Victory Park Capital was a great place for me to join in 2018.

Stewart: And it’s interesting, I’m not a private credit guy, but I learned a few things, and I love learning on these podcasts because I get to talk to guys like you. So there is a difference between cash flow lending and asset-backed lending. And we are talking specifically today about asset-backed lending. Can you give me the differences so that an audience, somebody, a CIO that just isn’t that familiar with the area can understand it starting from square one?

Connell: Yeah. So cash flow lending is really when a lender determines a loan size based on the borrower’s enterprise value, with a particular focus on EBITDA and cash flow. In contrast, asset-backed lending, generally speaking, is when the loan attaches specifically to a borrower’s assets and that forms the basis of the loan size. If you look at the ABL market holistically, how we look at it is, you can lend to traditional assets like accounts receivable and inventory, which is primarily done by banks. And, you can lend to non-traditional assets where we play and most banks do not. Examples of collateral in the non-traditional space can include hard assets like real estate or soft assets like consumer loans, small business loans, or any really verifiable or contractual stream of cash flow. In the direct cash flow world, you have broadly syndicated loans, which they call BSL loans, and that’s mainly where banks play. You have middle market loans and lower middle market loans, and that’s mostly where non-banks play. So, it follows the same themes. Asset-backed lending follows the same themes as cash flow lending, but it’s just a different structure.

Stewart: Okay. That helps. So can you walk me through what a typical Victory Park Capital asset-backed loan looks like?

Connell: Yeah. So the general characteristics that our loans have are it’s senior secured, delayed draw term loan. And when I say delayed draw term loan, that just means we don’t fund the entire commitment on day one. It funds over time. All of our loans have floating rate coupons and all of our loans have a full suite of covenants. And we directly originate all our loans and therefore we’re generally the sole lender, and always the agent because we like to control everything we can. And often our borrower is a bankruptcy-remote SPV, which stands for ‘special purpose vehicle’, which is basically a wholly-owned subsidiary of the corporate entity versus lending to the corporate entity itself.

Stewart: An SPV, so SPV and covenants, a special, if I understand this right, and believe me, when I tell you practicing law without a license, here we go. An SPV is what’s known as ‘bankruptcy remote’. So if the entity that issues the thing somehow fails, the SPV entity survives, it is not going to be attached to the issuer’s failure. Is that why it’s done that way?

Connell: Yes, practicing without a license, Stew, I don’t think so. You’re a pro.

Stewart: Okay. I’ll take it.

Connell: The reason for it is just to get access to our collateral as quickly in the event we need to. And so you’re exactly right, structuring it in that way allows you to do so.

Stewart: With regard to covenants, I think in private assets, that’s a really important consideration because there’s a liquidity premium that you mentioned. Can you talk about the typical structure of a loan like this?

Connell: Yeah, I’ll talk about kind of our structure and then the covenants that go with that, and some other operational controls that we have. So we lend at a max advance rate against the eligible collateral, which defines our borrowing base and we set what’s eligible and what’s not at loan origination. And keep in mind that our borrowing base moves, meaning it’s a dynamic pool of collateral versus a static pool of collateral.

Stewart: So that’s a really interesting point. That’s at a very important point that it’s not a static pool. And if something, if I understand this correctly, if something does default in the collateral pool, then it’s swapped out for performing collateral. Have I got that about right?

Connell: You’re right, it’s important. And exactly, it can be swapped in kind, with an eligible receivable or whatever the collateral is or in cash by the company because they have to meet the max LTV.

Stewart: LTV, loan to value.

Connell: Loan to value.

Stewart: Right. Okay.

Connell: You’re right on. So the borrowing base should always consist of eligible assets, which, since we set the eligibility, are always performing assets. And then, as the borrowing base grows, that’s why it’s a delayed draw term loan, so does our loan. So that’s the general structure. And as far as covenants we have, covenants are very important to us and we set covenants at the borrower level, which is the asset level. And, those are a little bit different than what’s eligible and what’s not. These are portfolio concentration limits and there’s a whole suite of asset-level covenants you can have, depending on what the collateral is. And in addition to those covenants, we also set corporate level covenants and that could be liquidity covenants, network covenants. So we have, from the covenant perspective, two lines of defense, if you will.

And in addition to that, we actively manage all of our loans, and really we do that by operational controls and ongoing portfolio management. So operational controls can be, we have security over bank accounts. Sometimes we have corporate guarantees. Then from ongoing portfolio management, we’re able to actively manage these loans because we most often have board observation rights, et cetera. So we like to say, we wake up and go to bed thinking about risk management. I think I hear that at Victory Park Capital twice a day. And what that means is, in other words, we have to monitor the performance of our loan collateral because that is the entire point of our underwriting. And given that there could be thousands of underlying receivables or loans or whatever the collateral is in our borrowing base, we have a full team that monitors that weekly or even sometimes even daily, depending on the type of collateral.

Stewart: I think, having run money for insurance companies for a lot of years and working on the insurance side, I think that downside protection is always as front-of-mind for insurance investors in particular. It’s ‘return of capital’ trumps ‘return on capital’. So it’s an important point with regard to the risk management and particularly right now. And we really didn’t talk about structure in terms of floating versus fixed rate. Right now, we’ve got a market of high inflation. There’s a lot of macro risks. We’ve gotten a gas tax holiday. That’s another form of stimulus. That’s not a political remark at all, it’s just a fact. And you’ve got rates that are significantly higher. I looked yesterday the 2 to 10 looks flat, 2 to 30 looks flat or pretty flat. How do you see this asset-backed loan strategy performing from here forward, given that ‘here’ is a lot different than ‘here’ was six months ago or seven months ago?

Connell: Yeah, we’re certainly in a market environment that creates a lot of uncertainty, and so you really want to be in defense strategies. There’s supply chain issues, there’s a war going on, there’s volatility, not only in the fixed income space, but in the equity space. So I think this is, private credit holistically, aspect lending or direct cash flow lending, really is a defense strategy. And then from an insurance perspective and an asset allocation, I think private credit, both direct cash flow lending and asset-backed lending have become an extremely attractive asset class due to just compelling risk-adjusted returns. So insurance investors now have comfort with private credit. It’s more mainstream, and has proven success through multiple cycles. And if you look at our ABL strategy, it’s a great complement to other private credit strategies in an insurance investment portfolio.

Connell: I think if the loan profile matches well with an insurance company balance sheet, from my perspective, from a life and annuity perspective. I think these companies can, and in my opinion should, take on some illiquidity premiums in private credit. And to answer your question on really the characteristics of our loan and how I think these characteristics can help in a time of uncertainty, I’ll just focus on four things. We’re floating rate, so that helps with interest rate volatility. Two, we’re senior secured in the capital stack so that helps with equity valuation volatility. So we’re kind of insulated in the capital stack. Three, we’re asset-backed, which helps with recovery rates in a higher default environment, which looks like a lot of people think we’re heading towards. And four, our loans do pay monthly interest so from an insurance perspective, it’s helpful for any J-curve risk and a really good match for life insurance companies, cash flow characteristics, other liabilities.

And also, I guess I’ll add one other thing. It’s private credit, so there’s capital-efficient ways to enter that space. And, outside of other things we do like structured products and mortgages, which there are ways to access this space, both direct cash flow lending and asset-backed lending where it’s not so capital intensive. So, I think it’s a really good space to allocate some of your portfolio in, especially in today’s market, but insurance, it’s a small margin business, so as crediting rates rise, you still need to make that spread on the investment side. And I don’t think that’s going away.

Stewart: Yeah. I saw a slide from St. John’s University yesterday that showed over the last 15 or 20 years, the investment portfolio, these insurance companies drive results. Buffet proved that years ago. It’s interesting. A little bit off-topic, but do you see the flow of funds to private assets continuing at the current pace as rates increase, nominal rates increase? Have you experienced any changes in the flow of funds there?

Connell: Yeah. Again, I think it’s pretty attractive. The floating rate aspect of this helps with raising interest-rate environment, but again, the insurance company’s crediting rates, let’s talk about an annuity company for an example, seven-year MYGAs are at 4.5% last time I checked, which was yesterday. Add some SG&A in that, you’re at, call it 5-ish and the investment-grade corporate Single-A index is at 4%, 4.8% today.

Stewart: And that don’t work.

Connell: That does not work. And that’s why insurance companies started getting into private credit. Now they have comfort with it because they’ve seen the realized performance. It’s a part of a lot of insurance companies’ asset allocation. And I think that continues to stay because it’s a spread business and if you put everything into Single-A to Triple-A, very liquid securities, it’s really hard to make money.

Stewart: And you mentioned liquidity, I do think the regulator, by all indications, the most recent regulatory changes that seem to make it easier for insurance companies to hold private credit, hopefully get some relief—CIOs have a very tough job these days. Seven months ago, all anybody was talking about was finding yield. And today, as you conclude in this podcast with our more focused remarks, everybody’s talking about risk management. The landscape’s changing and it’s an interesting asset class and one that I wasn’t familiar with. And I really appreciate you coming on and giving us a walkthrough. I certainly came out knowing a lot more and I hope our listeners did too.

Connell: Thanks, Stew. It’s great. Everything you do in the insurance space is very interesting. I’m a follower of your other podcasts.

Stewart: So that admission right there, Connell, will crush your social life. You may have just had some invitations canceled just on that comment alone.

Connell: That’s okay.

Stewart: I appreciate your kind words, I really do. And it’s great to meet you. We’ve got mutual friends here in Chicago and we’re very happy to have you on the platform and I appreciate everything very much. You’ve come a long way from that manufacturing assembly line in St. Louis to here as a partner of Victory Park Capital. Congratulations on your success and the success of the firm.

Connell: You too, Stew.

Stewart: We want to hear your ideas for future podcasts. Please email me at podcast@insuranceaum.com. I’m Stewart Foley, and this is the insuranceaum.com podcast.