182: Private Credit: Hype, Hazard, or the Next Big Thing in Long-Term Growth? With Huw Van Steenis, Vice Chair of Oliver Wyman.

0:00Huw Van Steenis:And from the financial crisis to, let's say, the pandemic, a trillion dollars of extra balance sheet was created in private credit in the US and maybe about a half a trillion in Europe and Asia. And so today, 43 percent of the assets in private credit, we think, come from insurance companies. Or put the other way, almost two thirds of all the new money in private credit in the last three years has come from insurers. by having insurers providing the finance, the private credit industry has structurally lowered its cost of capital and therefore it can be competitive for a far broader range of loans.

0:37Huw Van Steenis:Now, the interesting question then is, is that going to be in discretionary wealth? Is it going to be in retirement savings or is it going to be elsewhere? Well, if you're saving for retirement in 25 years time, to be stuck in only daily liquidity funds almost seems the wrong thing to do. And in fact, our parents all had access to defined benefit schemes where they could invest 5%, 10%, 15 % in private assets or in gold or real estate. So in a way, what we're trying to do is almost recreate what our parents had, but in the current format. Welcome to the Money Maze podcast. If this is your first time joining, I'm your host, Simon Brewer.

1:15Quick word before we start. 95 % of viewers aren't subscribed. so miss out on future interviews with top business, finance and industry leaders. To support the show and ensure we can keep sharing high quality content, click subscribe and please drop a like. Plus, if you have any future guest ideas, do share your suggestions in the comment section below. Otherwise, thank you for watching and listening and enjoy the show. When someone speaks with a deep understanding of the banking and finance systems, is widely respected and then expresses a strong but debatable view about a developing asset class, we think it's important to hear that voice and to challenge and distill its key messages.

1:58So today we welcome back a former guest who appeared on the Money Maze podcast in March 2023 during the banking storm in an episode we titled Risk or Opportunity. It was during the deep troubles of Silicon Valley Bank and then Credit Suisse, where his conclusion was unequivocally that this was no repeat of the 2008 Great Financial Crisis, as has indeed proved to be the case. With that, Hugh Van Steen is vice chair of Oliver Wyman, previously global head of banks and diversified financials research for 14 years at Morgan Stanley. And prior to that, the same position at JP Morgan. Welcome back to the Money Maze podcast.

2:34Huw Van Steenis:Simon, thanks for having you back. Well, I have noted behind you is a graph that goes classically up and then exponential and then collapses. So before we even start, for those who are watching on YouTube, what's the chart of? So it's Volmageddon, the inverse volume ETF, which obviously went to zero. My good friend Robin Wigglesworth from the Financial Times gave it to me. Very good. A former guest indeed himself. So there you go. There's a lesson in that which isn't today's topic. Now, you and Oliver Wyman have just authored a report entitled Private Credit is Reshaping Wealth Portfolios. And that seems relatively uncontroversial.

3:09But I did start thinking to myself, is it that innocuous? Is this a trend which will serve the private asset firms, but maybe at the expense of individuals? How do we think about bad times and souring loans? Does the loss of liquidity matter? Are we swapping risks from the regulated banking sector to the unregulated world of the giant private market firms? And how should we think about fees? So a few of the questions, not exclusively, that we want to address. So I guess that in boxing parlance, in the blue corner, we have Hugh Van Stienis and in the red, a more cynical investment battle scarred yours truly, who is less convinced of the irresistible investment case.

3:51Although I do see how the asset segment may have a very substantial runway ahead for many businesses. So let's start at a high level, Hugh. Banks have always been the lifeblood of economies and private credit has gone from being 500 billion a decade ago to an estimate by pre-COVID in the FT. There'll be nearly three trillion by 2028. Set the scene, please, first. What has been behind this shifting lending behaviours?

4:18Huw Van Steenis:Well, look, I think we've got this in a couple of acts. So I think the main act we should discuss is post the financial crisis, as we re-regulated banks, we discouraged them from taking riskier loans and quite frankly, smaller loans. So, for instance, in 2012, the Fed gave guidance on how many leveraged loans a bank could take. That provided a huge opportunity for private credit to pick up those loans which the banks were foregoing. And that was particularly on leveraged finance and mid-market lending. and from the financial crisis to let's say the pandemic a trillion dollars of extra balance sheet was created in private credit in the US and maybe about a half a trillion in Europe and Asia and so I think that was really a push as the regulators explicitly wanted the banks not to take these risks.

5:07Huw Van Steenis:What I think you've started to see in the last five years but particularly the last three is the growing role of insurance assets funding private credit and of course insurers have a very different risk appetite. They want to buy higher quality investment grade loans. And so today, 43 % of the assets in private credit, we think, come from insurance companies. That's up from 32 % three years ago. Or put the other way, almost two thirds of all the new money in private credit in the last three years has come from insurers. Now they want investment grade assets. So there's been a pivot, let's call it the next act, which was really to think about originating, you know, loans to hard assets, could be data centres, could be railcar, railroads, could be infrastructure, which are sort of higher quality, lower risk.

5:58Huw Van Steenis:And I guess what we'll come on to talk about is what's the next next act. And that's really talking about wealth. But in that, you know, I think that clearly that regulatory push was there. But also, we've seen that having a diversified system is quite frankly, good. So going back to the Basel rules, it discourages a bank from taking out to giving a loan much more than five years. If you're building a data centre or you're building a new toll road or energy infrastructure, quite frankly, you want money for eight, 10, 15 years. So actually insurance companies, which have got longer term horizons, actually are quite a natural provider of capital.

6:35Huw Van Steenis:And so I think what we're really starting to see, and this is something you thought about deeply, is who is the right holder of different types of risk. The more long dated it is, maybe banks aren't the right providers. And the riskier it is, the regulators don't want it to be the banks. So in many ways, this is, I think they are symbiotic, but obviously rivalrous as well. Okay. And we grew up in an era where I used to have the stripy AOBD bond book and we would look at bonds. And of course, you go to the euro bond market if you were going to issue five, 10, 30 year debt. Let's just make sure we're all clear on the definition of private credit?

7:10Huw Van Steenis:Private credit is an enormous category. And I think the way I think about it is almost in sort of three big blocks. So it's lending to a mid-market company. So for instance, maybe offering a$75 million loan to a company with a half a billion turnover. The larger banks don't find there's such an economic thing to do. And so they've ceded the ground to private credit. Second is leverage loans. So in other words, providing acquisition finance to the private equity community. And naturally, banks still provide that, but it's a natural asset for private credit because they know these companies well, and they know the sponsors.

7:45Huw Van Steenis:And then a third bucket is asset-backed lending. So providing finance where the collateral, the backing is a hard asset as data center, a energy infrastructure and so on and so we've almost got going from you know higher risk non-investment grade to cuspy investment grade to firmly investment grade and so i think you've now it's a much more heterogeneous space and so it's very difficult for me to say that what it defined in one word what is private credit um for the assets which go to insurers they are all rated Now, sometimes it's the bonds themselves, I apologize, the loans themselves are rated or the loans are packaged up, put into a securitization and then the securitization is rated.

8:33Huw Van Steenis:But one way or another, the insurers do need a degree of credit rating. And so there's also a really interesting subplot here, how the credit rating agencies are spending a far greater time actually helping private credit, you know, work out the standards and actually the credit quality. OK, and we're going to come back to that. So I understand the buyer profile and we're going to talk about the wealth channel in a minute. But let's just flip it to the issue, because if I've got my data right, Meta just issued a record breaking 29 billion private credit deal to fund massive expansion into AI. And just take me to the mind of the FD and the board of a Meta.

9:13What is it that they find attractive about this route?

9:16Huw Van Steenis:so well i don't talk about that what one specific company but what i think you're finding is um the private credit firms are not just competing with banks they are competing with the investment grade bond market and the securitization market so it's really it's a slightly different battle front and i think that's maybe underestimated by by certainly much of the media so what would be different is the the investment grade bond market is fantastic for vanilla bonds i want five-year bonds eight-year bonds, you know, I'm a high quality company. But when it's a complex deal, when it's a jumbo deal, or when it's very long dated, maybe sometimes the investment grade bond market isn't such a good place.

9:57Huw Van Steenis:And so what you're finding with many of these data center AI build outs, where the sponsor, if you like, or the backer is actually a very high quality, you know, large tech company, they're looking for a broader range of pools of capital and private credit is becoming increasingly compelling as a provider of finance and I think Simon in a way it goes back to the conversation about the insurers in a way we I mean I think sometimes what you're very good at is thinking about what are the longer term trends here by having insurers providing the finance the private credit industry has structurally lowered its cost of capital and therefore it can be competitive for a far broader range of loans than it could do when it was offering a 12 % loan to a private equity backed acquisition.

10:45Huw Van Steenis:So I think that structural trend is why we're starting to see this blossoming of very large complex deals play out for the big tech firms. So before we continue this conversation, we're going to take a short break to have a note from our sponsors. IFM Investors is a global asset manager, founded and owned by pension funds with capabilities in infrastructure equity and debt private equity private credit and listed equities they believe healthy returns depend on healthy economic environmental and social systems and these are evolving on a scale never experienced before to find opportunity build value and meet the needs of future generations you need scale skill and expertise.

11:29That's what IFM Investors has built up over 30 years. In times of economic and geopolitical volatility, investors will look to gold. Today, as the world navigates uncertainty and heightened risk, investors of all sorts will look to safeguard their wealth. We're thrilled to welcome the World Gold Council as one of our sponsors. tap the link in the show notes to learn more or visit goldhub.org on your browser for comprehensive research insights and analysis on the global gold market okay clearly expressed i absolutely get that insurance piece as we think about the wealth universe very different both because of the emotional mercurialism time horizons which change given bull or bear market and would it be fair to say that a lot of this individual appetite really started at the time when there was a search for yield during the zero rate era?

12:30Huw Van Steenis:So I think that the zero interest rate environment clearly called for an interest for many investors. But I think the growth in wealth really has really popped up in the last sort of five years. And I think that, again, thinking big picture, this is started with the most sophisticated and largest pools of capital, family offices, the extraordinarily wealthy. And then it started to come to the very wealthy. And I think the real innovation at the moment is, can this then be offered to the mass affluent or accredited investors, particularly in the States, who would like to, quite frankly, have the options that an institutional investor can access.

13:09Huw Van Steenis:So we think there's something like 12 % of the assets of the major private market firms are now coming from the wealthy. That's up from 8 % three years ago. Put it the other way around, money from the wealthy is growing four times faster than from a classic institutional channel. And we think that probably 80%, 85 % of that is from the spectacularly wealthy, but it's starting to grow. And I think the really interesting thing, Simon, is then the development of, or basically fund innovation, the combination of technology, affording access and simplifying the document process, and innovation on the funds is allowing a sort of democratization of access through evergreen funds.

13:56Huw Van Steenis:So in other words, rather than putting your money away for 12 years, it's actually saying from day one, you can start to put it into an existing pool of assets. And that development of the evergreen area is probably the single fastest growing part of the investment industry this year. We estimate in the States, evergreen funds in the first half have grown annualized 60%. And so I think this is an area where there's a lot of it. We can talk a bit more about how you structure it, but that's really the real focus for the industry. And you see something of an irony, maybe it's a cynical irony, that the very time that yale were championed by david swenson with his brilliant approach to portfolio management looking for that um illiquidity premium at the very time that yale has announced it's substantially reducing its commitment to private equity and other private assets the slats being taken up by the individual by the individual world that who in at large and maybe that's more retail that perhaps has a habit of coming to the game late so i think it's a bit more nuanced than that simon so obviously the u.s educated universities have got a number of issues and i always think in finance it's never one thing it's the it's the combination of two or three thumps at the same time and so obviously uh the response to the anti-semitism on campus and so forth obviously there's a series of issues which are leading to the universities to need to call cash the second thing at least the report we were focusing on this case was around credit.

15:26Huw Van Steenis:And I think that you know that since we had the biggest increase in interest rates for 45 years, it has had a profound way on thinking about what is the right asset allocation for an endowment for an individual. And if like, in a way, fixed income is back. And actually, the last three years, many people had not really thought a lot about fixed income and are now really rethinking. And so if you look at it, what I'm really struck by the endowments, and you spend a lot of time engaging with them, they have very, very little in private credit. Almost all their private exposure is actually real estate and private equity and venture capital.

16:02Huw Van Steenis:Actually, private credit is peanuts. I mean, if I give you a statistic, let's go even not just the US endowments, take the Aussie Superfund, which I think I agree with Mark Groen. I think the Australian superannuation system is the best system in the world. they've got about 15 to 20 percent in private assets but the largest fund has only got two percent in private credit so actually the credit piece is i think in a very different category now when you come to retail you know i think we need to think about are these going to be in you know um diverse what's the right structure to make sure that if you're investing in a liquid asset that both the client has got the option to get out but it's actually but you're managing the asset liabilities really well.

16:47Huw Van Steenis:And so I think it's interesting to me that the majority of the money in the last few years has come through business development corporations, which are like an investment trust. And so they are sort of closed-end vehicles. The innovation at the moment are through interval funds, which have got quarterly liquidity, typically up to 5%. And look, there's one fund out there, which is 60 % public bonds, 40 % private bonds. Well, There's an awful lot needs to go wrong before you can't sell. You know, you start to have liquidity issues. There's another new fund, which I'm quite intrigued by, which has got about half half between public securitizations and private securitizations.

17:24Huw Van Steenis:So, look, you know, as with any wave of innovation, there'll be things, lessons learned. But I think at the moment, the fund innovation looks quite responsible and quite well thought through to address the asset, the potential asset liability mismatches. Well, I'm sort of going to ring the bell using our boxing analogy for a pause, because before we get to those risks of which I think there are a few specific ones I want to address, just staying high level, because you have quite rightly pointed out over the last few years, there's been a shift in the approach to fixed income investing. and you have dubbed it, you and others, but the barbell approach, you've written about it and you say it's a smart evolution in fixed income thinking.

18:05So because this is part of the jigsaw, just give us your minute or so on how that thinking and why that thinking has evolved.

18:13Huw Van Steenis:Well, so if I think about it, so when I was back at Morgan Stanley, actually back just over 20 years ago, we coined this term, the Asset Management Barbell, to describe the polarisation of portfolios. And back then we were thinking between index funds and the nascent ETF industry. So in other words, cheap, reliable ways to get access to broad market indices. So cheap. And at the other end, spicy, you know, looking for higher risk return allocations could be hedge funds, could be private assets, could be private credit. And that polarization has probably been one of the defining trends for investing in equities.

18:52Huw Van Steenis:And we all know the success of BlackRock and Vanguard, State Street and others really benefit from that. And I guess that, you know, I wasn't really in the market to sort of dust off an old concept from 20 years ago. But when I looked at that interest rate shock, it really made me think, actually, what we're now starting to see is that barbelling of portfolios is coming in earnest to fixed income. And just to give you a statistic, just six years ago, 15 percent of the U.S. retail industry in fixed income funds. So in other words, mutual funds and mutual funds and ETFs, 15 percent was in index ETFs.

19:29Huw Van Steenis:As of last month, it's now 30 percent. So there's been a doubling at the cheap and cheerful end. And what we're starting to see is clients looking also to put it into more interesting slices of risk. Now, for the very wealthy and for the accredited investors, so in other words, ones who have got a degree of wealth and are sophisticated, they can put their money to work in private credit. And as I said, we've seen a two and a half fold increase in assets in the last three years. But my thesis from here is that this barbelling has got another decade to run, if not two decades to run on the fixed income side.

20:04Huw Van Steenis:And so that's why I start to think about the role of private credit potentially in mass affluent portfolios. Now, the interesting question then is, is that going to be in discretionary wealth? Is it going to be in retirement savings or is it going to be elsewhere? And I think there are going to be very different pockets. But the real interest, of course, is there's$12 trillion in retirement savings. At the moment, allocations to private assets are close to zero. Well, if you're saving for retirement in 25 years time, to be stuck in only daily liquidity funds almost seems the wrong thing to do.

20:42Huw Van Steenis:And in fact, our parents all had access to fine benefit schemes where they could invest 5, 10, 15 percent in private assets or in gold or real estate. So in a way, what we're trying to do is almost recreate what our parents had, but in the current format. So in other words, I don't view it quite in such a scary way, but I think this but obviously we need to be doing it in a very responsible way and make sure that the conduct regulators, the SECs and others, you know, really understand the issues and can be can help the industry develop in a thoughtful way. So whilst we all know that passive investing in equity has been largely proven to be right, given the difficulty about performing these indices, the really interesting thing, which slightly sits sort of on the other side of your position, is that whether it was Manny Roman from PIMCO or Greg Peters from PGM, the evidence is there is still quite a lot of alpha to be achieved in the world of fixed income, unlike the world of equity.

21:38So a world that's pivoting to passive increasingly does make you think, well, is that the smart thing? And you and I both sit on investment committees. How have you processed that?

21:49Huw Van Steenis:Well, look, I think it is a no, I think it's a very good challenge. So, look, I think let's go down one bunny hole. What's really interesting to me is that the pandemic actually turbocharged the growth of ETFs in fixed income. And that's because as all of us were at home, and particularly the traders were at home, the liquidity in the bond market actually pivoted very quickly towards ETFs. So the primary way to have liquidity in the bond market is now ETFs rather than underlying bonds, which is a dramatic change. And as everyone went back to the office, they kept with that convention. So I think the liquidity of the fixed income market has surprised all the naysayers, you know, and particularly all the central bankers who are a little bit worried about ETFs as a fixed income construct.

22:34But your point really is then, how do you get the plus plus?

22:37Huw Van Steenis:So in other words, if you've got your core holdings cheaply, how do you get the core plus or what I've been dubbing in the latest note core plus plus? So in other words, you're trying to get access to private credit too. Now, one way is you do it as a slice on its own. And I think for the very wealthy, that makes perfectly good sense. And whether it's an Evergreen fund or a J.K.E.R. fund, that's obviously going to depend on the suitability for the client. But what we're starting to see, though, is the role of Credit++ in a broader portfolio. And I think this year you've got a lot of innovation around that.

23:09Huw Van Steenis:And again, maybe doing a longer term sweep and thinking about your great interview with Manny. Well, actually, if you think about what PIMCO did 25 years ago with their total return bond fund, one of the ways that they outperformed the index was they started to use derivatives. And back then, that was completely novel. And really, people weren't using derivatives. A couple of years later, the SEC then gave guidance on how to use derivatives in a classic mutual fund structure. Now it's business as usual. And so I think in a way, one of the possible subplots here, as we start to see a blurring of lines between public and private bonds, actually, I wouldn't be surprised if popping in some private credit and a portfolio will be very much like the derivatives of 25 years ago.

23:56Huw Van Steenis:and also as you remember Simon from your time long Stanley the derivative guys took over the cash equities business because actually they came with new tools and I think that's the other interesting play here is we're starting to see a mushrooming of partnerships between private firms and traditional long only firms partly because the private firms don't have access to 300 ,000 independent advisors in the states let alone many tens of millions of clients and so I think there's also a potential story here about what does this do to the structure of the traditional asset management industry. And I think that's something which we'd like to come back to time and time again over the next five years.

24:35Huw Van Steenis:So I think it's a very profound change. Okay. And before we leave this, you alluded to, and I think it's worth just coming back to, the role that technology is playing in facilitating the dicing and slicing of asset pools, suddenly making it more accessible for individuals just comment on what that is because pipes are being built by firms you and i know that is you know is important new infrastructure oh no i think it's great i think that tech is one of the three key enablers of this trend now but it's but it's everywhere so it's uh what are the right platforms on which to place uh assets companies such as icapital again i'm not trying to pick on one but it's an example who are providing a platform and access um we are starting to see the ratings agencies start to think about their role in the private market.

25:27Huw Van Steenis:Index funds are thinking about the role about can they create indices and benchmarks so that risk can be assessed and the portfolios can be assessed for individual clients. And again, technology is enabling to do that at smaller clip sizes than for institutional investors. Documentation. I mean, as you know, signing up for private investments is typically very heavy on signatures and paperwork. And so there's a whole element of work to try and simplify the process. We're also starting to see even some tokenization. I hate to bring that word up here, but there are starting to see the vote to try and simplify the process.