The real reason that private equity, private credit has been so interested in the insurance space is because it provides them an avenue to basically a socialized backstop, which, you know, makes sense. But I guess I wonder, in the course of your research and actually talking to private equity and private credit, how aware are people of the current regulation scheme for bankrupt, failed insurance? Does it come up a lot?
I think one of the main ways that this ends up playing out is that, you know, what people are often thinking about is turning back to the permanent capital angle. Am I allowed to just, like, make my investments without somebody yelling at me about them? And one of the reasons why, if you have a life insurer, you can make kind of whatever investments you want without, like, nominally the creditors of your company or the investors in your company coming in and yelling at you is because not having people yell at you is like a very underrated incentive in the world. But I think it's one that probably is very important.
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway and I'm Joe Weisenthal. Joe, there's a key tenet of finance and investing, and I think it's like essentially the thing that makes finance and investing work.
It is the idea that you can invest in pretty much anything. The world's most stupid thing. I don't care, Dogecoin, whatever. But the key thing is, if you do that and the investment doesn't work out and it goes belly up, you should bear that loss.
Yeah, I think that's right. I would actually ideally, by the way, you invest in something that doesn't have negative externalities for other people. But, you know, let's just focus on the loss portion for a second.
Yeah, I like this framing. I think the way, like, you could say that financial structures overall, whether we're talking about a bank, whether we're talking about a multi-strategy, multi-platform hedge fund, whether we're talking about whatever, is an exercise in trying to establish this purpose. Right. Because everyone wants to make the investment that they don't bear the loss. And right. That's like, we should all, to some extent, we should all be striving for that constantly. And so you want to build up these things that more or less create that to happen, principal-agent alignment problems and so forth. And so when you get moments in financial history where losses are not purely borne by investors, yeah, people often get very upset.
And as you know, 2008 was one of those moments, right? One of the reasons the 2008 financial crisis was such a huge deal was because we had banks who made a bunch of risky investments and ended up getting effectively bailed out by taxpayers, even though taxpayers arguably were not the ones deciding to invest in synthetic CDOs and things like that. Even in the absence of bailouts, it always bothers people when someone makes money on a risk and then someone else holds the bag. From the bailout example to people who promoted SPACs and made a lot of money just on the transaction but didn't participate in the downside. All of it upsets people, right? And so all across finance, you see situations where people are upset when it turns out that the person doesn't have the requisite, quote, skin in the game, unquote. No one wants to be an unwilling bag holder. That sounds bad, but I want everyone else to be like, we, I strive.
Okay, okay, but wait, the reason I bring up 2008 is because it's actually a very important component of this conversation, because we're going to be talking about private credit, and private credit to a large extent has grown into this massive industry. And the reason it's grown so much, one of the reasons is because after 2008, after the banks went belly up and had to be bailed out, etc., you had policymakers make an active decision saying that they wanted to move risk out of the regulated banking system into investment vehicles, where if things went wrong, the investment vehicles themselves would bear the losses without having those losses socialized through deposit insurance or taxpayer-funded bailouts and all of that. And that's what basically happened, right?
Yeah, I would say there are sort of, in the financial system, we have sort of, I would say, two types of creditors. Like, we're cool with, like, people losing their money when they give money to an institution, they take a risk. But I think there's essentially two types of entities for which we don't find that to be fully acceptable. We don't find it to be fully acceptable when someone deposits their money in a bank. And we, you know, we could say this is a loan, right? But we don't really want to accept that this is a loan. Like, we don't want people to have the confidence in putting the money in the bank, I'm not really making a loan to the bank. And then I would say the other category is insurance holders. And we don't really like the idea, you know, someone who owns a policy. It's a little bit different than a loan. But I think the idea of, like, an insurance holder as a bag holder does not sit well with people on a sort of democratic, sort of societal level.
All right. You have totally anticipated the next thing I was going to say, which was we moved risk out of the regulated banking system into private credit.
Yeah. Which seems fine. Yeah.
It's like, all right, risky, risky loans, all that, middle company deposit holders don't have to worry.
If risk is now migrating back into another regulated financial industry that we do care about for the reasons you just stated, which would be insurance, that doesn't seem ideal either, right? Having credit risk migrate out of the banks into private credit, and then having private credit migrate into insurers.
Yeah. And, you know, like, I think insurers and banks aren't really that different. It's sort of the difference is the timing and the liquidity with which you can get the money back out of your, whether if you're a depositor, can you get your money out on demand? If you're a policyholder, or can you get your money out either at a certain time or on an event in which the policy triggers? But fundamentally, I've always thought, you know, it's kind of the same business with a different sort of redemption schedule.
There are differences between insurers and banks, which we're going to talk about for sure. But one thing I should just say is we have discovered in the course of this podcast that one of the driving forces behind the private credit boom has been its linkages with insurers for some of the reasons that you just said. So insurers famously have long-dated liability, right? They have patient capital. They can take an illiquid asset and sit on it for ages and ages and capture that illiquidity premium, that higher yield. So they would seem to be a natural place for private credit to actually end up. But as we mentioned before, it does open up this whole new can of worms about losses and who actually bears those losses. So this is what we're going to be discussing today: the insurance, private equity, private credit nexus in excruciating detail. And I'm very happy to say we do in fact have the perfect guests. We're going to be speaking with Andrew Granato. He is assistant professor of law at UT Austin, as well as Pranjal Drall. He is a JD-PhD candidate in financial economics at Yale University, and they just published a really good paper. It is called Private Credit, State Backstop: How Private Equity Socializes Risk Through Insurers. Great. So truly the perfect guests. Andrew and Pranjal, thank you so much for coming on Odd Lots.
Yeah, thanks for having us.
So why don't I just start with the basics. But we know that insurance has teamed up with private equity in various ways. Some private equity firms own insurers outright. Others have, like, minority investments or, like, different business relationships. What is the attraction or the allure of insurers for private credit?
You can think of this as being so. McKinsey has called this a flywheel. So imagine you have, like, a private equity firm with three subsidiaries. You have a traditional, like, buyout subsidiary that buys up companies and uses leverage to do so. You have a private credit fund which issues these high-risk, high-yield loans. And then you also have a life insurance entity. There are theoretically all these different synergies between all of these actors. So if I go and I need to buy some sort of company or someone has to issue debt in order for me to be able to do that, maybe a different part of my PE firm can issue that debt, and maybe I can get better terms that way. But then there's also this aspect of, you know, if I have a private credit fund, you know, these are funds where, you know, I have LPs who are constantly, you know, making demands for returns. But if I have a life insurer, I have these very long-dated liabilities where arguably the capital is like what we're told, it's permanent. So if you can hold these private credit loans that are highly illiquid on the balance of the life insurer that you're issuing to other firms in your portfolio, you can imagine that this is like a scenario in which you kind of theoretically get the best of all three worlds.
One more way to think about it is that private credit has become a large asset class. Insurers want access to that private credit, and instead of having an in-house team that just learned how to do private credit investment, they go outsource that to a big PE shop, which has developed this business over two decades in some cases, and essentially outsource and use these economies of scale to outsource part of the lending so they can still do the, you know, publicly traded sort of borrowing credit that they've always done and outsource part of the lending to more specialized shops. I mean, this has been extraordinarily successful. This sort of realization that these things could merge has just made people an extraordinary amount of money. It should be noted, you know, one of the most famous investors of all time, Warren Buffett, utilized this core insight that in insurance, having an insurance arm would be an extraordinary source of patient capital. You know, we talk to, like, mutual fund managers, and one of the questions we always ask them is like, isn't it tough that in a market drawdown, you can't actually hold it? So we, you know, because your clients will move on to the next fund. I mean, this has already for a very long time just been an extraordinary, fruitful partnership.
Yeah, it's definitely not something that's new. What's new about private equity in the last 15 years or so is the degree to which they have kind of ramped up the aggression of the investment strategy that they are pursuing with, by one, by purchasing these life insurers at such high volumes. Recent estimates have maybe like something like $750 billion of life insurance assets kind of within private equity's purview. And then the degree to which they are shifting the portfolios of their life insurance firms. You know, until quite recently, life insurers were famous for having these, you know, it's that's very kind of stodgy Triple-A rated AT&T, you know, bond portfolios. And that becomes less and less true across the industry in general. And that's a trend that's being led by private equity, particularly with regard to these, like, affiliated private credit investments and their other portfolio companies.
Yeah. So this is the key thing, I think. So, you know, insurance has transformed private credit by supercharging its growth. But at the same time, insurers themselves are being transformed by private credit. Can you talk about exactly, like, what does that relationship look like in practice? So you mentioned affiliated assets, which have been in the news recently for reasons we can definitely get into. But if I'm a private credit, you know, originator and now I have bought an insurer, what does that relationship look like? Am I dictating that or am I telling them what they actually need to buy? Am I making polite suggestions? Am I making sales pitches and saying, well, you got first crack at these very elite, previously exclusive private assets?
That's a great question. So, as you can imagine, there's a lot of nuance there where certain asset managers. So just to set the landscape, Allianz, for example, owns PIMCO and Allianz, the insurer. And this happened in, like, starting 2000. So the idea of having an asset manager make investments on behalf of the insurer is not new. The second point there is there's a lot of variation in how that contract works out. So the most sort of, in our, you know, parlance, problematic or concerned we should be is about when the insurer balance sheet is effectively in control of a bigger asset manager. So the idea there would be that the insurer doesn't have as much discretion. Discretion, they're just at the behest of the broader asset manager. Or you can imagine an insurer goes out shopping. I want the best private credit shop to invest money on my behalf so I can capture the liquidity premium, offer better terms to my policyholders by making more money. And in that case, you know, there's like a lineup of really sophisticated shops that will, like, try to earn that business. And in that case, you can imagine the dynamic like a third-party agreement where you're outsourcing part of your balance sheet to an asset manager. And that's totally, like, you can imagine a very competitive marketplace for that service, because insurers, as you said, manage large pools of money. So, you know, there's like a big spectrum there, one where the insurer has effectively given up full control of the balance sheet and the other where the insurer is essentially looking for who's going to offer me the best terms to invest my money in this very specific segment. And you can imagine, you know, a spectrum of possible arrangements there.
So if I'm an insurer who's owned by a PE shop, I'm paying them management fees as well for those assets.
Okay. And you're, so you're paying management fees in both cases usually. It's just in the third-party context, since you don't own the insurer, you'd imagine the insurer has better bargaining incentive.
Exactly. Oh, yeah. And there's also many cases where, you know, the insurer as part of a private equity kind of like sponsored platform is not just paying out fees for management, but it's also paying out fees for essentially all sorts of other affiliated services, like a, you know, you could imagine accounting. You can imagine valuation consulting, all sorts of things where it, yeah, yeah. Where, like, the insurer is kind of like the balance sheet of the insurer is a holding pattern for a lot of the assets. But all the action is actually outside of the insurer's corporate form and the rest of the kind of PE sponsor.
How much competition is there among insurers to gather assets? Because it's like, okay, here is Insurance Company A, and they're going to pay me, you know, $5,000 a month for life because I've bought this annuity every month for the rest of my life after I turn X age. And here is another one. But this one is paying all these, like, IT services and all these little things that maybe, like, come out of the return, etc. Does the end market of insurance purchasers have much clarity on what they're buying and the economics of two different policies?
That's a great question. So, it's a hard empirical question. Yeah. So there's a thing called in finance called the annuity puzzle, where in theory, annuities are the perfect investment. But society as a whole underbuys them. And a lot of finance professors have spent decades puzzling out why that is the case. So we're not going to solve it here. But one of the lessons from that literature is that people underinvest in annuities because they don't get a good deal. Prices are too high, the policies aren't that good. There's competition, but the end consumer doesn't get a great deal, or they at least perceive they're not getting a good deal. So there's always been this concern that for some reason, you know, the market isn't very competitive. Now, you might imagine if an insurer is owned by a shop and they make a lot of money on the private credit, illiquidity and all this, you know, because high returns and all this stuff. So, and they're in fees. So in some ways a shop that owns an insurer might offer better terms to policyholders because they have all these other ways to make money from the business. So we've seen some empirical data that, like, by owning an insurance company, you actually, that PE-owned insurance companies compete better in the private market. So you can imagine the consumers might benefit. The problem there is, of course, that, you know, you might get a good deal in the short run. But, you know, decades down the line when things come to you, there might be problems.
If I'm in the market for an annuity, do I, should I, or do I have any capacity to take into account credit risk? As someone who grew up or became an adult kind of during the GFC, I was like, I don't know, like, I'm going to retire in like 20 years. Who knows who's going to be around. To what degree either does that or should that be part of the information that the purchaser of the annuity has?
Yeah. So it's very difficult, I think, for retail policyholders to meaningfully grasp the degree of solvency risk that their kind of counterparty annuity provider or life insurance provider, you know, has. And so something that we think is really fundamental is that, you know, the investors in, say, a private credit fund, you know, nonprofits, you know, endowments, big institutional investors, pension funds, they're in a very different position than just, like, normal people who, like, don't know about anything. Well, you know what this insurer is doing with all of the money? As far as I know, they just bought a life insurance policy, and I'm, well, you know, most people haven't even thought about what happens, like, kind of on the other side of that balance sheet. And that asymmetry is what drives a lot of the, like, I think the results that we're going to speak about.
So okay, speaking of asymmetry, you have the McKinseys of the world out there who will talk about this being a virtuous flywheel where, you know, PE gets access to these big pools of permanent capital, and then the insurers themselves maybe get access to higher-yielding assets that then generate better returns for investors, better products, etc. On the other hand, you also have critics of this practice who will point out that because of the nature of private credit, because these aren't publicly traded bonds with, you know, double A, I guess now, or maybe triple A ratings for some corporates, you don't necessarily have the level of insight into what these things are and what their true riskiness is. Talk to us about what we know about the actual private credit assets on insurer balance sheets, and what regulators can actually see and know about these things.
So this has been a, you know, a topic of discussion for the last two years, almost, I feel like this almost obsession of how much should we trust private credit valuations. And that's a problem in BDCs, which are, like, you know, publicly traded. And you can see the quarterly marks on these loans and you can see, you know, there's a privately traded BDC and the public traded BDC. No, one, and the public one trades at a discount. So there's always been this concern that the valuations aren't, you know, kosher or they're overvalued in some ways. So those same kind of intuitions apply here. Except the crucial difference is the regulator, in this case the NAIC, which is an association of regulators, essentially has visibility on insurers' balance sheet. And they look at everything they invest in. This can be equity, cash, safe bonds, whatever that means. And private credit bonds. And all the insurer regulator sees is the value reported to them, which is usually outsourced to a third party, rating agency. And then they see, like, this private credit loan is valued. It's like a double A. And then they give you a notch on a scale of 1 to 10. And you get this picture. As an insurer, these private credit assets are X amount of safe. These privately owned assets are less safe. And there's like a spectrum. And then the regulator says this is a good portfolio. It's safe. And like banks, they have to hold certain amounts of capital against that. There's a whole risk grading team through the NAIC that is like somewhat analogous to that of banks.
And I think a lot of the concern applies here as well, too. Like there were concerns in 2008 about what are the incentives of the credit rating providers, the incentives for what are often called private letter ratings, and for life insurance are kind of particularly skewed. These are ratings where the rating itself is actually not kind of publicly visible. So a credit rating agency, someone like Egan-Jones, might report to the NAIC, you know, here is our rating for this asset. And you know, how was that rating obtained? Can anybody else, like, investigate? Is there any sort of track record to compare this against? It's just extremely difficult. And so there's a variety of new empirical literature in economics that's coming out basically every week where people will come to do various sorts of tests and they'll just continually find overvaluation in a lot of these assets.
