Defining private placement in the context of insurers' investments

In the first part of this Insurance Asset Risk / Loomis Sayles roundtable, insurers discuss the benefits of investing in private placements and the evolving nature of the marketplace.

Vincent Huck: What is the advantage for insurers to invest in private placements?

Sean Collins: Private placements are a core allocation in our portfolio and that will be the case regardless of market conditions. We use privates to fill in portfolios with specific asset classes we cannot get on the public side. Privates also provide diversification, higher yields than publics though less liquidity, and better downside protection.

From an insurance portfolio perspective, privates are a capital-efficient and defensive asset class, which makes them attractive as a core allocation.

Chris Gudmastad: One of the key attributes of private placements in addition to the spread over publics, is with the recent introduction of esoteric credit to the asset class, where there is the potential opportunity to get a complexity premium in addition to illiquidity.
In addition, the covenants and structural protection can be key as a buy and hold investor, as it seeks to minimize downside risk throughout the cycle.

Andrew Hanson: Probably worth highlighting too, diversification is a big deal in privates. Because the kind of companies we do debt private placements for are often not going to come to the public debt markets. They are brand new names for insurance company investors in an environment where a lot of public-only bond investors have trouble diversifying because of the concentration of large public borrowers.

Sean Collins: About the downside protection. Strong covenants are going to allow you as a lender to get invoice quicker and work directly with the company to navigate any short-term challenges. This provides better downside risk protection compared to the public high-yield market.

Mary Beth Cadle: And we clearly saw that during the GFC, when we held a stressed credit which had issued in both the private and public markets. Private investors were able to negotiate security, coupon bumps and forced prepayments with make-whole fees at a time when the public bonds were marked at 40-cents. It was a great outcome and return, versus the public bond equivalent.

Colin Dowdall: It's important also to define the terms. When you say "private placements" to an insurance company often times they think: corporates, sleepy market. And when you talk about some of the evolution of the market, things like project finance and the structured area, specialty finance, [that] is when they start to understand the full universe of it.

It is, frankly, something that the industry now is grappling with, because how do you underwrite investment managers that are in this market when everybody defines it differently. We are also seeing that with third-party consultants that they themselves are taking a step back and are trying to create a definition so that they can look at the market apples to apples. However, this is not the 20-30 over a public investment grade BBB corporate bond, there is so much more to this market.

At Loomis Sayles, we have defined it as "private fixed income," and as simple as it is, that little nuance means you do not get that immediate reaction and you get an interest in really digging in and understanding why do we call it private fixed income instead of private placements, and how do we define that universe more broadly.

Chris Gudmastad: It is a more accepted term and we are starting to see non-insurance investors investing in the asset class as well—pension funds, endowments, infrastructure funds, and sovereign wealth funds. As these investors invest in the asset class, I think private fixed income is a better way to define it. I would also say the quality spectrum is not just investment-grade anymore. We are certainly seeing non-rated and high-yield issuance and will likely see more as the market evolves.

Dmitry Baron: Aflac has an interesting relationship with private placements going back 10 15 years. One of the reasons why Global Investments in New York was created is private placements. Aflac had traditionally a fairly large portfolio of private placements, very concentrated, so during the global financial crisis it did not necessarily do that well. Thus, to diversify away from private placements the platform in New York was created.

However, now, going back to a couple of years ago, we saw an opportunity to go back into private placements but we define it slightly differently. We do need to have structure on top of just being private for us to qualify as an investment opportunity. Having said that, we have a very strong Yen-denominated private placement book, which works very well for us, because Aflac has significant part of its business in Japan.

Mary Beth Cadle: So when you say you need structure on top of it being private, is it an asset-backed structure or are you referring to structure as defined in a project finance deal or a transaction that involves a more complex organizational structure and covenants?

Dmitry Baron: I guess an easy definition for us is whatever doesn't fit anywhere else. However, we view it as private ABS and corporates with a twist, private corporates with some kind of special purpose vehicle, receivables-based financing, maybe an insurance wrapper, something like that.

Chris Gudmastad: As you look at why these opportunities exist, taking a step back, we believe it is because the banks stepped away from the markets - our industry is replacing banks. We are focusing on infrastructure, as well as specialty finance, which could also be defined as esoteric private credit or private ABS.

And we are seeing an increasing issuance in our market. It is not just pure corporate. It is not a multi-tranche ABS; it combines the structural aspects of both ABS and corporate credit. That just shows the flexibility of structures in our market and we believe it is also a result of new investors in the market, mainly alternative and non-insurance institutional asset managers.

Nakul Nayyar: Insurers are long-term investors and so well placed to capture the illiquidity premium across private placements. After the global financial crisis and certainly during COVID panic, there was an emphasis placed on liquidity. While we still need to manage for things like outflows, surrenders and other liquidity events, there is more comfort looking at illiquidity in the portfolio than there was perhaps five or ten years ago.

Mary Beth Cadle: I would challenge a view that private securities are inherently illiquid. In my view, liquidity is a continuum with some off-the-run public bonds less liquid than well-known, high quality private placement issues. Furthermore, public markets are liquid only until one really needs liquidity during a market downturn or in times of volatility.

Illiquidity in the public market can also be priced a bit differently than in the private markets. Sometimes you can get a higher premium for illiquidity in the public market versus privates, depending on where you are in the cycle, and in a particular sector.

Andrew Hanson: I agree with you. When we talk to issuers about doing private versus public, or private versus 144A versus Agented 144A versus 4a2 private, there are so many nuances of the legal form of issuance. And theoretically in the textbook that has something to do with liquidity; but what has more to do with liquidity is the name, access to information, credit quality, deal size, and number of investors in the deal. If you do a supposedly illiquid private placement for a single-A corporate with 25 investors in it, I would say that is going to be a lot more liquid than many off-the-run BBB public deals issued once every ten years that don't have a strong following on the street's trading desks.

It is more of a name by name thing. We know it when we see it but it is hard to define what is liquid versus illiquid.

Vincent Huck: How have you seen this space evolve over the last few years and how has it impacted the way you think about those investments?

Mary Beth Cadle: When I started in privates, the market consisted of a very small group of investment bankers and U.S. insurance companies, with issuers often privately held and typically more mid-cap in size. We then saw the advent of commercial banks where they leveraged their lending book to drive supply. As a result, larger, often publicly-traded credits began to issue private placements. The next driver of growth were cross-border companies, which opened up the UK, Europe, Australia and New Zealand as new geographic jurisdictions.

The point seems to be that whenever investors question how to deal with supply-demand imbalance, our market creatively develops other sources of supply. I give private capital markets a lot of credit for being innovative.

Andrew Hanson: The early wave of market growth in the 2000's was international and then probably ten years ago, the project finance growth wave started really taking off. I actually think that is what has helped lead to this earlier discussion about the breadth of private fixed income. It started with project finance and all of a sudden there wasn't a clear definition of who is buying these deals, and whether they were considered a "traditional" private placement buyer or not; but they are structured deals that are illiquid and add value. The asset class started to be defined a little bit more broadly. And now that has just accelerated private fixed income and what you were talking about earlier regarding esoteric assets.

Colin Dowdall: It is not a coincidence that it coincides with the entrance of private equity capital into the insurance market, which is 12 years when it formally began as a risk transfer strategy, and has accelerated. And we are seeing in the last 18-24 months there have been more changes in the life insurance market than there were in the prior 30 years, because you just had such a dramatic re-shifting of assets to different forms of ownership and, frankly, different philosophies around investments and how to potentially optimize yield per unit of capital consumption.

Chris Gudmastad: That has brought a lot more sophistication to the market. It began with project finance, as banks stepped away from the asset class shortly after the global financial crisis. The recent wave the last 2-3 years is private ABS, which can be also called private structure fixed income or esoteric credit. And the way I would describe the market today is when the transaction comes to an analyst, it is like a lump of clay. You do not know what the final form is going to be. You do not know if it is going to be corporate or structured, bond format or loan format, but individuals and firms need flexibility to offer solutions and have the expertise necessary to structure, underwrite and price the risk.

Dmitry Baron: We definitely see a lot of new players in this space. We are now competing with hedge funds, asset managers. And they are yieldy deals – rated closer to investment grade, but paying like high yield, because of the supply on one hand and yield requirements from non-traditional players.
Sean Collins: There is also a natural fit for insurance portfolios, where you have a need for high-quality, long duration assets. Managers can help fill the gaps in insurance portfolio with higher yielding, short-term assets. These can be opportunities such as esoteric ABS or below investment grade that offer a yield pick-up with some level of downside protection. Private Equity firms have driven some of the evolution we've been discussing, but insurance company specific needs are also helping to drive the shifting opportunity set as well.

We were in this low-rate environment for a very long time, and in the low-rate playbook, you saw a lot of insurers going down in quality, taking on more illiquidity, or extending duration to pick up yield. As we go through the next downturn, there will be assets that come out of that period will a lot more attractive valuation. Additionally, managers are increasingly focused on finding opportunities that are structured in a capital efficient manner for insurance portfolios.

Vincent Huck: Protection was mentioned earlier, have you seen that evolve over the years?

Mary Beth Cadle: I think protection evolves more over market cycles. Depending on where you are in the market cycle and the resulting supply/demand imbalance, covenant protection can become competitive. Then just when you think covenant packages can't become any less meaningful, there is a downturn and everybody tightens up the covenant requirements. That said, the private placement market tends to have stronger covenant terms compared to other participants.

Chris Gudmastad: As a buy-and-hold investor, covenant packages are important, considering we are going to most likely hold through the cycle.

That is why we believe it is important to have a highly selective process. That being said, considering the investor base, covenants are not going to go away from the private investor market.

Andrew Hanson: I agree with Mary Beth [that] it ebbs and flows. I don't think it is dramatic ebbs and flows, but you can definitely feel it on the margin even year-to-year. However, I would be hesitant to say there is some long-term trend for looser or tighter covenants.
Sean Collins: You still have stronger covenants in the private placement market than you do in broadly syndicated loan markets.

Mary Beth Cadle: However, do you think with new entrants into our space their covenant requirements will be different or be perceived as being different? Recently, when we aren't able to get the documentation points required with our deal bid, there are questions as to who is willing to do weaker terms.

Nakul Nayyar: Investment committees and organizations are generally cognizant of the risks of covenant-lite packages. There are plenty of conversations, particularly in the CLO and Broadly Syndicated Loan market, and its effect on recoveries going forward.

Andrew Hanson: Every investor thinks differently on a particular deal about covenants, just like you guys think differently about credit. And sometimes, we see an investor who might be more lenient on covenants, but in our opinion their credit selection is good. Covenants are not necessarily the most important thing, just seeing it from the sell-side perspective. However, I have seen newer players who do want tighter covenants, whereas, other do not. I am not sure I could generalize if newer players are coming in with less covenants; and if they are coming in with less covenants, I do not necessarily think they are making a mistake. They may be picking the deals that are better from a risk-reward standpoint even if they are more lenient on covenants. It's just the flip side of that argument.

Dmitry Baron: Coming from the bank loan side, that is absolutely right. Like, over the last 3-4 years, you might have ended up with negative selection. If you wanted to focus on the deals with covenants, those would be the weaker credits.
Having said that, in private placements, because we are married to the deal for long time, we want to make sure the covenants are there to protect us. You do want credit quality, obviously, but also covenants; otherwise, during the next cycle you might not do well; you might not be able to exit if you need to. Thus, covenants will be there to get you a sit at the table to negotiate the deal, to get screws tightened, to make sure that the recovery is there.

Sean Collins: It feels like it could be a risk. However, there is still a tremendous amount of insurance money out there that outweighs the new entrants into the market. And we keep saying a buy-maintain is a conservative approach to portfolio management and asset allocation, so it feels like that is still an overwhelming factor. And on the covenants, that is the value of also having a direct origination platform. If you have the direct relationship with the borrower, then you are going to have a greater say over the covenant package.

Chris Gudmastad: Speaking on behalf of the new entrant in the marketplace, Loomis Sayles has a deep value credit culture and that is not going to change. One of the keys for us is to not just slap a covenant package on a transaction, but one that matters. One that helps minimize the idiosyncratic risks, gets you a seat at the table to re-price the risk and potentially get taken out of a transaction.