Episode 294: Insurance and ABF – What’s All the Hype About?

 

Stewart: Hey, welcome back, and thanks for joining us. I want to make mention of our upcoming Philadelphia event that is focused on ABF real estate and infrastructure. We have a few spots for LPs remaining, and if you're interested, and what I mean by that is insurance and investment professionals. If you work at an insurance company in short, shoot us a note at events@insuranceaum.com and we'll get a registration packet headed your way. I think we've got two LP spots remaining, and we'd be happy to have you. So,  just to kind of follow on with the theme, we've got a phenomenal podcast for you today. It was very topical given my recent announcement here, insurance and ABF, what's all the hype about? And we're joined today by Keith Ashton, Partner and Portfolio Manager, also Co-Head of Alternative Credit at Ares Management, and we're also joined by David Ells, CFA Partner, Portfolio Manager in Alternative Credit at Ares Management. Gentlemen, welcome. Thanks for taking the time.

Keith: Glad to be here. Thanks for having us.

Stewart: Let's start where we always do. So Keith, where did you grow up? What was your first job? Not the fancy one. And what was your path to get to your current position at Ares?

Keith: Well, where I grew up is a bit of a difficult question to be honest, because by the time I graduated high school, I'd moved 21 times and I attended 10 schools. So it was all mostly in the Rocky Mountain West, and that includes all the states that you can think of, plus a little bit in Alberta. I had a little bit of a circuitous route to this industry. I started my career, believe it or not, in advertising. And then, when I was much older, almost 30 years old, I went to college. And so I was a freshman with a bunch of 18-year-olds, which was not super fun, but then I went straight through there, went to business school after college, and then got my first job at an insurance company, TIA Cref.

Stewart: Oh, wow. What a great story, though. I was a first-gen guy, and when you're 30 years old and you go back to college, I mean that takes a lot of initiative. I really appreciate that. So, David, how about you? Where'd you grow up? What was your first job, and what was your past to Ares?

David: Stewart? I grew up in Milwaukee, Wisconsin and never moved, lived there my whole childhood growing up. My first job from age 16 through I think 21, I was a summer camp counselor at YMCA camp, and I used to take 10-year-old boys on five-day canoeing trips, overnight canoeing trips. So that was what I did in my summers through high school and college. I came to this business pretty soon after graduating college with an economics degree. I started out actually as a bond salesman at Smith Barney when I was 23 or 24 years old. And then by way of my now wife, then fiance, I actually met Mark Walter back in the mid nineties in Chicago and he offered me a job to come work at the predecessor company to what is now Guggenheim, and I was going to go to business school and he made me a deal that he would pay for it if I got straight A's and came to work for him. So it was kind of an interesting way to get into the business and I worked there for about seven or eight years, moved up to Northwestern Mutual Life, spent 15 years inside of an Insurance Company doing a whole bunch of different jobs, both related to investing and management, including being the Head of Asset Allocation and Portfolio Management. And then about seven years ago, I came up with the idea of doing what I'm doing now, which we'll get into, and met Keith in the course of looking for that, and came over to Ares.

Stewart: That's super cool, and I think it's worth mentioning. I mean, I worked at an insurance company also, and the fact that you both have deep backgrounds and deep experience in an insurance company, I think it's irreplaceable experience. There's lots of folks who talk about managing money for insurance companies, but it is different being inside. You're so much closer to liability, so much closer to the business, I think. Can you guys just talk about how you think that experience with the insurance inside the insurance company is paying dividends for you today?

David: Stewart, you're right. Working inside of an insurance company isn't an experience that can be replicated anywhere else, especially running fixed income money and actually being down in the weeds and doing the work. You just can't, there's no substitute for that, for understanding all the accounting, all the capital, all the nuances that go into the different aspects of being an insurance-specific portfolio manager. And I think what that allows us to do, both Keith and I, because as you pointed out, we both have deep experience doing this, is it really helps us relate to our third-party clients in the sense that we know what the problems are that they're trying to solve. And so we're able to anticipate what they're doing, and we're able to build these products for them with an eye on having solutions already crafted for what we know are going to be issues that are going to be important to them.

Stewart: Yeah, it's interesting because your team is well known for regularly reflecting on past experiences, which you share in this piece that you put out called Top 15 lessons learned. Could you highlight two or three of those key lessons that insurance investors should be particularly focused on?

Keith: Well, I think given that those lessons were born of investment experiences that we've had throughout our careers and particularly those inside insurance companies, I don't think there's a lesson that we refer to there that doesn't have some relevance to an insurance investor. But I'd say, looking at the world these days or today anyway, there are probably two that jump out at me. One is “What we call risk is exponential, even though the market may price it as linear.” And I guess what we mean by that is the more you go out on that risk curve, your risks don't just move linearly, they move exponentially. However, we get into situations like we've been in, maybe not the last couple of weeks, but year to date mostly where we were seeing the credit curve flatten and you were getting paid less and less to go out on that risk curve, so to speak, and it was becoming pretty crowded.

And that to us is always an indication of mispriced risk when the market is pricing it that way. So I think it's a good lesson, a good reminder generally of how risk in markets may be uncorrelated where they ought to be. The other one is “Watch the flows,” which is we have a newsletter our team puts out called In The Gaps. It's read by mostly institutional investors, but really it's available on the website. It's our musings and observations about asset-based financing markets and our insights into that world. And in our last couple of editions and, in particularly our last edition, we focused on how the tides of capital and liquidity were distorting risks in markets in some ways, but just as importantly, just how quickly those tides can go out and the rip currents associated with that can be devastating and can be very punishing and unforgiving. So it's another good reminder of paying attention to those flows of capital and liquidity because they can feel good on the way in, but they can feel horrible on the way out.

Stewart: How about you, David? What are the lessons that you've talked about that you would bring up here? I mean, Keith, I really think that the way you were explaining risk is really insightful, and I think that as both of us avoiding losses is critical to insurance companies, I mean it's paramount…

Keith: It's the job. 

Stewart: It's the job, right? Absolutely.

David: Yeah, Stewart, you're absolutely right. And in essence that you're answering the previous question, which is you have to understand that about insurance, right? It's about avoiding losses as much as it is generating excess return. For me, the one that I would point to is lesson two on our list, which is buy assets and cash flows. The rest is noise. And for two people that have been doing this for a very long time have, as Keith and I have, the times you get into trouble in this business, and Keith and I both have the scars to prove it, which is where the lessons come from, is when you forget that, when you forget to look at assets and cash flows and focus on those things and you get caught up in the story, the narrative, the “this time it's different” and all those different things, and you forget if I just focus on assets and cash flows 99.9 times out of the a hundred, you're going to get the decision right on the asset because what you're really trying to do here is avoid losses.

Stewart: Yeah, it's a great point. So ABF is certainly hot right now. And it was interesting because early in my career, and as I mentioned to Keith, I was a first-gen college student and there was a lot of times when I didn't know what people in the room were talking about and I was afraid to ask because they didn't want to be shown a fool. But, oftentimes, I think people toss terminology around, and they kind of know what it means, but they don't exactly know what it means. And so when you start talking about asset-based finance and alternative credit, it would be helpful, I think, for you guys to help define that in the way that how we're going to talk about it today and how it differs from other forms of private credit.

Keith: I'll take a crack at that, what we call Alternative Credit at Ares, but goes by many other names in the market, including the new popular one is ABF or asset-based finance can also be called asset-backed investing or asset-backed credit securitization or ABS is another popular acronym. They're largely synonyms. There's nuanced differences that David and I might make a big deal about, but generally speaking, they’re synonyms and what we're ultimately describing or talking about is, and the most I would say defining characteristic of these types of investment is that they're based, and you're investing, in a pool or portfolio of assets. Typically credit assets, loans, leases, financial receivables, there's some contractual cashflow, it's enforceable, and you're lending or financing those pools in contrast to corporate type investing, which tends to be based on a single entity, a single counterparty, and you're taking single name risk.

An ABF investment might have hundreds, if not many thousands, of underlying assets in a portfolio or a fund of ABF investments can have millions of underlying assets. And so by definition, you're kind of operating in this world that is inherently more diverse and granular in terms of risk than you would tend to see in other types of investments. And if you do that properly, and what I mean by that is if you're competent, you have analytical capabilities to tackle that data. Then the investments themselves offer some interesting benefits. I mean one of those obviously is the risk benefit, and the other is, in these markets in particular, yield benefits. So you can talk in terms of higher risk-adjusted returns because you can generally, for the same rating or same credit risk, achieve a premium versus doing corporates with the same rating.

Stewart: This is something I don't think we've ever talked about on a podcast, but I remember back when the Earth was cooling and we were running structure, and there was a big difference in analytics. Even then. There were commercially available packages that you could buy, but the best shops had their own analytics. Your point about being able to accurately define the cash flows gets back to David's point about keeping your eye on the assets and the cash flows. So, would you be okay to talk about what kind of analytics are involved, and do you have proprietary or are you relying primarily on commercially available analytics?

Keith: I can take that. It's a combination. I think Stewart, you would still be disappointed to know that there aren't off-the-shelf solutions for everything that we would love to do. And a lot of what we end up doing happens to be proprietary, either the analytics or the use of databases and data science to get at it. I think we'll take everything we can get approach in terms of analytics and data and try to use and synthesize all that information. But I think, fundamentally, if you get your head around the fact that you're going to be investing in an underlying pool or portfolio, then the analytical framework then is being able to stress those underlying assets in some way as credit investors. That's what we're always worried about is just the downside. And to do that, you need to be able to model those underlying assets and their associated cash flows and impose various scenarios on them not making the bet that there won't be, there'll be zero losses in that underlying pool or portfolio.

You're assuming there will be, and you're trying to assess, well, how bad can it get before we take a loss? And is that scenario one that I think is likely or totally unlikely? So that's the framework that you think about, but you need those analytical tools to do so. And unfortunately we found that, or fortunately I guess part of the value add that we think we add as investors and managers is the ability to do that work, to do it competently and as part of a process to be able to do it repetitively over time and find our way through different market environments.

David: And Stewart, I would add to that, and Keith made this point implicitly, and so I'm going to make it explicitly as a follow on to him, which is the reason the excess return exists in a lot of this stuff is because there is not an off the shelf package that makes it easy to analyze these things. It's hard. I mean, we have 80 people that work on this and just in our group and we've got a lot of young people who spend a lot of time cracking data tapes and doing Excel analysis on pools and things like that, that it's not like I just pull it up on Bloomberg or I pull it up on Intex and I run a few scenarios and I feel pretty good about it in terms of what I'm buying. It takes a lot of work to get at what the underlying risks are.

And so one of the things that we talk about a lot in this space is: are we getting paid for taking risks here? And the answer is unequivocally yes, we are taking risk. What are the forms of that risk and the decomposition of that excess return? Well, there's an element of credit risk to it. There's an element of liquidity or lack of liquidity in the premium that you're getting in this space. And then there's the structural complexity that goes along with it. Can I analyze it and determine the good deal from the bad deal? And all of that goes into generating what is the excess return in these types of assets. And so having that ability to do it and the fact that it's not commercially available, readily available to be able to do that is what creates a lot of that excess return.

Stewart: And I think if memory serves, it's not only getting to the data, but it's also being able to figure out what the data's telling you and knowing what to look for, and based on your experience. I remember we had a competitive advantage at one point, given our ability to do that. And so I think that's important. So, just to switch it up a little bit, insurance companies have been an important source of capital in the private credit space as banks have pulled back; insurers are funding a lot of things that banks used to. So that leads me to my question about insurance capital in ABF. And so, what role does insurance capital play in ABF markets today and how do insurers benefit from participating in this asset class? Which I have to say, based on the feedback that we're getting on our agenda on our July event, is a very hot topic right now.

David: It very much is. And so I'll answer that in two ways. The insurance capital to the ABF market is significant. It's probably the most important pool of capital there. And a lot of things getting done in asset-based finance are getting done with insurance capital being the primary holder of that risk after it's been molded into whatever it's going to be. And we've seen, of course, a lot of private equity capital move into the insurance space. A number of private equity firms now own or sponsor insurance companies. So a lot of those structurally complex assets are being designed to move onto those balance sheets. The other part of the answer to that question, Stewart, of course, is that asset-oriented investments on insurance company balance sheets are becoming a much more significant portion of the balance sheet. You're an old fixed income guy from your days in insurance, and you remember that corporate bonds were 40, 50, 60% of the portfolio, and we own some govies, and you own some agency MBS, and that's kind of what your fixed income portfolio looked like. And what we're seeing now is that the private credit portion of the balance sheet can be anywhere from 25 to 50 or even 60% of the portfolio. And the structured sub-component of that we see as high as 30, even 35% in some insurance companies, usually the PE-oriented backed ones. And in even more traditional insurers, we're seeing that number move through the high single digits and into the double digits. So it's a symbiotic relationship in that the investments have become much more important to the insurance companies as well.

Stewart: Yeah, you mentioned back, I have been at this for a minute and it has changed so dramatically from when, I mean, it used to be that insurance companies had a core bond portfolio and a walk on the wild side was 5 to 8% high yield, and it's just a different world today, and the sophistication level is up and the table stakes to be able to be a player in these markets. The table stakes have gone up, I think.

Keith: If you don't mind, Stewart, I’ll just throw one other point out there, which is, well, as David and my career attests, this is not a new thing for insurance. However, until pretty recently, and I want to say maybe going back to 2017, 2018 timeframe, it was fairly clubby. In other words, only the largest of the insurance companies were participating in ABF markets at all. And that left a lot of others out. And the reason why it left others out is that if you didn't have your own team internal doing this, you had no way to access this market. And so for the very reasons that David came ultimately and joined Ares is a reason why ABF and insurance is becoming increasingly increasing focus by insurance on this because now most insurance companies have real access points to this market, and particularly through asset managers and those with that expertise in house being able to offer the strategy out to insurance companies of all size. So it's gone from being very clubby and almost exclusive to a lot more accessible by nearly every insurance company out there for the first time in its history, just happening in the last few years. And I think it's a big part of the reason why there's a groundswell of interest in it.

Stewart: That is super helpful, that perspective. Thank you. Just to kind of go into challenges and market developments. So given your background and current vantage point, what are specific challenges that insurers face when they're trying to access ABF opportunities, and what are some notable recent market developments that you're seeing right now?

David: I think the challenge, Stewart, for most insurers is that they have a traditional way of doing things and pivoting to be able to develop the expertise to this is from a human capital point of view, from an allocation point of view, it's a big culture shift and it's a big change in the way they've done business. So if you're used to doing more traditional type fixed income and you want to build a team to do this, you need a great deal of expertise. As we pointed out, we have 80 people who work on this for us as investment professionals, and you have to have expertise in the underlying asset types. So in order to look at a transaction, anytime we underwrite a transaction, right, we go back to the cash flows and Keith pointed this out and we look at the variance around those cash flows, what's the range of outcomes that could happen here?

And then we have to take that expertise and we have to marry it with the structure that we've received or the structure that we're negotiating. And I always talk back to the GFC in 2008, and as we came out of that, we had subprime auto and subprime mortgage. One of them did a lot better than the other. And there was no downgrades, no defaults in subprime auto. Same borrowers are doing subprime mortgage. That one didn't turn out quite as well. And so it's a matter of how do you build that structure around that asset? Do you understand the asset and can you put a structure around it that protects you from those adverse scenarios? I think building that inside of an insurance company can be difficult, and I've seen it done at very large insurance companies, but it's a real commitment from a human capital point of view to do it.

Stewart: Yeah, I think that's a great point. And not only that, but if you make a decision to change your allocation, that's a lot more difficult. If you've invested in a large team, you've almost have to stay in the asset class, right? So I think it's fair to say that not all platforms are created equally. And you had mentioned the resources that you've got committed to this asset class. You're one of the largest alternative asset managers globally. How does your alternative credit team collaborate across the broader Ares platform? And can you share an example of how you've leveraged the collaboration on a deal or strategies?

Keith: Sure, I'll take that. The other I'd say big shift that has started and is ongoing, and I think it's in a way where the puck is going to borrow a Gretzky phrase, is that there's two sides to this market, the ABF market. There's the public syndicated, banked side that everyone, most folks would be familiar with, the asset-backed security side. There's a private side to this market, directly originated, directly negotiated transactions. The market historically has been dominated by the former, the public syndicated side, and only in the last few years has the private side really taken off. And that's where most of the focus has been: directly originated transactions. It's another challenge that some insurance companies will face is they may only have access to the public side and not the private side. They don't have those capabilities internally and they haven't hired a manager to help them do that.

But that is an area. Speaking of areas where Ares has real expertise, Ares is a private credit shop. I mean that's three-quarters of the capital, give or take, that we manage entirely here. And having that credit and lending DNA running in the air around here gives us certain advantages in terms of origination on the private side, which is again where we see the puck going in particular in this market. So that's one element of that, having those origination capabilities, those are relationships with sponsors, and that understanding of the process of creating something from a clean sheet of paper as opposed to buying something from the street. My partner Joel sometimes uses the analogy of: Are you a chef or are you a food critic? There's a big difference in your approach to things. I would say that in tandem with that, a lot of, we source a lot of opportunities through other parts of Ares. I'll take one sector, as you mentioned, an example, I'm sure you've heard of fund finance or NAV lending.

Stewart: Absolutely.

Keith: Which is lending to other funds. Very interesting market that used to be owned or dominated by banks, and now private capital is playing a bigger role. Well, it's lending against a fund, and often, let's say it's a private equity fund. Well, very often the relationship with those private equity sponsors is managed and day-to-day interacted with our colleagues in direct lending in both US and Europe. So they have the relationship with the sponsor who may be looking for a fund solution. And so them understanding Ares as a partner, as a reliable partner for them on an individual, single-name basis, and then having that, bridging that to a broader relationship at the fund level or even the GP level. It's an easy bridge for us to walk over. And so we get a lot of sourcing there. And then just thinking through that underlying, we would obviously have some pretty interesting insights on the underlying components of any fund to be able to diligence and understand the risks a little better.

So I think if you think through it a little bit, there's a lot of natural capacity to enhance what we're doing in ABF land through collaboration with our colleagues. The question is, do you actually use those resources or not? And a lot of institutions are set up very in a very siloed, almost a territorial, competitive way. Whereas one of the things I love most about Ares is that we don't have that issue at all, really. It's a very open, collaborative, encouraged environment that we're in.

Stewart: We've had a phenomenal education on this space and appreciate both of you being on. Could I just ask you each to give one kind of takeaway that you'd like our audience to leave with? If you could just both give me one quick takeaway from the podcast that you want folks to remember.

David: To me, Stewart, the biggest thing is that there's an allocation decision to be made here. If you're an insurance company in this market, and unless your liabilities are either not very or you're not worried about them walking away from you with the industry called sticky, I think you have to be looking at this space. You have to be, otherwise your liabilities can't be competitive with other people. And I'm talking predominantly life annuity, but even PC, less so the real specialty lines in this space. And so approaching that allocation decision in the right manner with the right thought process, I think is super important. How do we want to make our foray into this space? Your point that you made, which I love because thought about that and talked about it for years, is if we hire a bunch of people, we're kind of stuck with it and it's really hard to pivot and go in a different direction, is one of the examples of the thought process that needs to go into that. So it's really important in the allocation decision to think about how you're going to do it and the implementation of it. 

Stewart: How about you, Keith?

Keith: Well, I often like to zoom out and just look at where we've been, where we are, where we're going, just to get a sense for both opportunities and risks. I think that gaining that perspective is a big part of building any business successfully, investing over time and that sort of thing. And I would just reinforce the fact that this groundswell of interest and the activity that's going on in private credit in particular, but asset-based financing specifically with insurance, it's not a fad. This is a part of a secular trend and shift with insurance. Tying into what David was saying about an allocation, this is truly where the puck is going and there's good reason for it. It's not, again, chasing yield. It's a way for insurance companies to calibrate to a greater degree the risks that they're looking to take to achieve a higher return or yield on their asset portfolio versus more traditional allocation approaches. And to do so in a way where they have the same or better downside protections that they're already enjoying and appreciate as insurance investors. So I just think there's a reason why the attention and the focus is on it and it is part of a longer trend that we should expect to see for the next 5 to 10 years at a minimum.

Stewart: That's super helpful. So, I got a couple of interesting, a little bit on the closing side. One's fun and one is, I think, important for people coming up. So the first one is when you're adding members to the team at Ares, what characteristics are you looking for in the candidates that you speak with? I don't mean school or Excel or Python. What characteristics are you looking for?

David: For me, the first thing, obviously, Stewart, we have a level of intellect we're looking for, but then the first thing I'm looking for is team fit. How is this person going to get along with the team? How are they going to interact with it? And then when I dive deeper into an interview or an assessment of somebody, I'm trying to get a feel for how do they look at things, bigger picture, what's their ability to see around corners, especially with younger people, they're relatively early in their careers and they're still building up a lot of experience, but I want to see if that thought process is heading in that direction. Are they a head down and I just want to get the work done, or are they, the head comes up and I want to look around and say: Hey, wait a minute, what's the implication of what I'm working on? 

Stewart: Super helpful. Keith, do you want to add anything there or you want me to go on our final question?

Keith: I'll just make two quick ones. One's kind of related to what Dave said. I'd put it in terms of we like super ambitious people, but not competitive people. I think there's a big, big difference. Competitive folks are hard in a team environment. Ambitious people are wonderful in a team environment. So that's where I draw the line around that. And then patience. We have with that ambition can sometimes comes a lot of impatience. And I think investing in particular is a game of experience and experience takes time and reps. And so I think to be patient with that learning curve, that growth trajectory is a big part of developing oneself as a credit investor first and foremost. And I think in our markets, it makes you a better investor overall if you're patient and allowing yourself to go up those learning curves and establish some real credibility as opposed to time and seat.

Stewart: Really helpful. Alright, fun one on the way out the door. Dinner for four, both of you and you each get to invite one guest, alive or dead. Who's coming to dinner with you? David, let's go with you first. Who's coming to dinner with you and Keith?

David: Oh, okay. One guest, by the way, I love the guy who did the broadcasters a few weeks ago. I thought that was great.

Stewart: Me too. Yeah. Yeah, I thought that was good too.

David: I like that he had a theme, so I had three people ready.

Stewart: It's, oh, okay. Listen, we can make it a larger deal. We can make the table bigger. We'll have Rob Torretti there. Everybody's there. Let's do it.

David: I'm bringing Winston Churchill, and if I got another seat, I'm bringing Ike. My caveat is I want it to be in 2025. I want to hear what they think about what's going on in the world right now, what the parallels are to what they had to deal with.

Stewart: That's interesting. It'd be amazing to show those to an iPhone, wouldn't it? You just go here, look at this. Yeah, it's crazy. How about you, Keith? Who would you invite?

Keith: Personally, I always had a fascination with explorers and pioneers and folks that are doing something or going somewhere for the first time or doing something that other folks thought was impossible. So I've always been drawn to that and I'm certainly not alone in that fascination. So my mind tended to go there. I read a few books on Teddy Roosevelt a few years ago, and while he was as a president did a lot, away from being a president he had a fascinating life as an explorer and adventure as a pioneer. I think he would have some of the craziest stories ever to tell about those experiences. So I'm kind of in the camp of, I love to hear crazy story experiences from people having done something that I would not have the courage myself to do.

Stewart: That's great. Good stuff. It's been a great podcast. Insurance and ABF. Now we know what all the hype's about. We've been joined today by Keith Ashton and David Ells at Ares Management. Gentlemen, thanks for being on.

Keith: Thank you.

Stewart: Thanks for listening. If you have ideas for a podcast, please drop me a note at Stewart@insuranceaum.com. Please rate us like us and review us on Apple Podcast, Spotify, or wherever you listen to your favorite shows. My name's Stewart Foley, I've been your host for the home of the world's smartest money at InsuranceAUM.com.