Private Credit Is the Fuse, Insurance Companies Are the Bomb with Nick Nemeth

0:00Thank you.

0:30WisdomTree has built a suite of ETFs designed to offer exposure to companies connected to defense, security, and the geopolitical forces shaping the modern economy. If you're thinking about how geopolitical dynamics could influence markets over the long run, it's worth taking a closer look. Visit WisdomTree.com slash geopolitical dash opportunities to learn more. All right. You guys, you're going to learn something today. and maybe be scared out of our wits. Private credit is the fuse. The bomb is underneath the life insurance industry. That's my guest, Nick Nemeth, the author of Mispriced Assets on Substack, where he's been writing extensively about risks inside the private credit markets and the growing connection between those markets and the life insurance industry.

1:24Believe it or not. Private credit is now a multi-trillion dollar asset class. The US life insurance industry sits on roughly$10 trillion of assets. And increasingly, those two worlds are intersecting with private credit moving on to insurance balance sheets. Nick, I'm so glad you're here to explain your ideas to the audience. Say hello for us. What's up, Compound? Thanks for having me on downtown. All right. We're thrilled to see you. I think investors keep hearing about how are there a quote, how there are problems with private credit, right? So they hear it on TV all day. They read about it in the Wall Street Journal and in Bloomberg.

2:06I think because it grew so fast and maybe one of the major concerns is that anytime something grows as quickly as this has, it sort of sneaks up on people. And then when they hear that there is maybe shortcuts in the way money was raised, maybe miscommunications, whether intentional or unintentional between the primary conduits of that money being raised, in this case, it would be financial advisors and the wealth channel, etc, etc. Sometimes you just have like this general sense of unease, but people have trouble putting their finger on what the problems actually are. And that's what I hope we can do today.

2:47So we're going to start with the foundation of the private credit issues that you have identified. And then we'll get into what you say is the fuse that's triggering this financial crisis. And we're going to do this at the end. But just for people to understand, Nick has been writing furiously about this issue at mispriced assets and I think has become one of the primary voices on this particular topic. So we're really getting it from the horse's mouth. So let's start at the foundation. You've argued that private credit returns look smoother than they really are because they're not marked to market, they're manager marked.

3:27So I would say that that is like the best place to start for an audience of investors and financial advisors. What is that problem and why is it problem in the first place. Well, people talk about volatility laundering for a long time on private equity. And that's, you know, originally you got paid for the illiquidity and now it seems like that's more of a feature than a bug. So there's a lot of, there's a lot of stuff that's been said before, and then you have to kind of follow it to what it means. We've seen an asset grow from essentially nothing to multi-trillions. And whenever you have explosive growth, especially in credit, you have to worry about, are the valuations correct?

4:15And if the valuations aren't correct on the equity, private equity, the majority of this asset class is just LBOs. So they're talking about LTVs, loan to value, how much of the total value is debt. And, you know, people are specifically talking about software. It's been well covered. Everyone says it's not systemic. And the further you look into it, you realize, okay, this is not central to the banking system. This is not huge on bank balance sheets, but it's still a huge issue. Okay. So people are saying, so people like yourself are saying, look, you've got funds out there that are invested in hundreds, in some cases, thousands of individual credits.

5:02Many of these particular loans were loans made to an industry, the software industry that is now under siege. We see this distress in the public equity markets every day. The stock market opens. Some of the largest SaaS software companies are trading down 10, 20, 30, even 40 % from their highs. And there's this constant drumbeat of all of these companies are facing this disruption from AI, et cetera, et cetera. So now you're going a step further and you're saying, well, if the public equity markets look this way, then why do we feel good about the loans and the private credit side of this? Because it's the same companies or smaller companies.

5:51So if we think Salesforce, for example, is in some degree of distress, what is a$50 million privately held software companies loan actually worth relative to what the lender is saying it's worth when they report to the credit investors? Is that the heart of that issue? Yeah. Or what about Figma, right? The selection to be in the public markets, you have to meet a bar. Private equity, they haven't met that bar. They would get access to more capital and cheaper capital. If you're looking at the cost of debt for these companies, 10%,

6:32it's really hard to have that be your hurdle rate on capital. And there's a reason for that. if you could get public market debt if you could go to the public markets you would do it okay so so these are companies that are not public uh they're private and we have to go by what the lender says these loans are are worth yeah and it's based off of assumptions that are borderline insane. Give us an example.

7:12There's many different layers to how these guys price this debt. But rolling into it, if you're in a software valuation, Bcred's a great example. Blackstone's huge in software. They underreport it. All of these guys underreport it. You can say it's just because they have to or because they're trying to hide the software. I'm not trying to get into that argument. But when you go through the business services, first of all, they say 25 to 26 % of assets is software. When you really look through it, you go through the 400 businesses they lend to in B-Cred. And by the way, BSXL is 80 % of the same loans.

7:56That's the publicly traded BDC. you're looking at like 33 um journalists say it's 31 i think it's more like 35 percent of software on assets but then they're running at 1.7 times leverage so it's really over 50 percent of their you know for people thinking you know having having a portfolio it's like being on margin You have$100 ,000. You just bought 55 % in Tesla. But then you bought on margin, you bought Pfizer and some other stuff. And there's definitely no Pfizer's in these portfolios. But if that goes down 50%, the loans, then you're worried about taking a wipe of 25 % off of their NAV. And what you're seeing in public markets is they're saying, we don't trust the NAVs.

8:56And it makes complete sense. The narrative that I'm seeing out of the private equity guys, it's like I'm taking crazy bills. You have John Gray saying that worst case scenario, apocalyptic, is our nav is off 3.5%. And I'm like, that is the apocalyptic scenario you're preparing for? That the memos are crossing your desk? By the way, this is our downside risk at Blackstone. And if Blackstone is saying that, and that's how they're underwriting risk, what is the 50th ranked PE company doing that's trying to keep up and get a little bit of gravy in this? So are we talking about isolated pockets or just software or just a certain type of software that's being marked incorrectly relative to the disruption risk slash the macro picture?

9:52Or is this across the entirety of private credit and every fund, every large fund, every small fund, there is some version of this happening on their own portfolio? go. If all you need to understand is the software component in order to realize there is an issue, okay. I think that's a red herring and that's what they're going to want to push to. The underwriting across the board is crazy. They're running seven times leverage on EBITDAs that are sponsor marked. They add back whatever they want. There's no, you know, if you look at - Sponsor, I'm sorry, sponsor marked meaning, and you phrased it this way, they're checking their own homework.

10:39So sponsor marked valuations, meaning it is worth 99 cents on the dollar because they said it is. Right. It's sponsor marked EBITDA. You know, they're doing these adjustments you wouldn't believe. I don't want to get too far into it. But at the same time, it's also good times multiples. Right. We're in a healthy environment. I'm sorry? We're in a healthy economic environment, meaning we're not in a distressed economy yet. Right. Even when we go into a recessionary period, which is 2022, technical recession, no, but it wasn't a great time, they don't adjust anything. The only way that they adjust anything is if they look at the loans that are clearing.

11:34Again, another selection effect. In software right now, Databricks, huge. Databricks is huge. Databricks is a great company. But now they're comparing to the Databricks being the entirety of the capital markets for these types of loans. so you know i think the marks are tremendously off but i don't think it's just software and that's where people need to start understanding it's like okay if you're putting seven times leverage on ebita on hvac companies at 18 times you know 15 if it's a roll up maybe it's 14 um you have you have an equation where there's so much debt on these businesses that have variable outcomes, especially during a recession.

12:28And the EBITDAs themselves, every deal that they do, they usually miss by 25%. Over 50 % of the time, they miss in year one and two by 25 % of their assumptions. So I think the underwriting across the board is questionable. Can I ask two questions to play devil's advocate that I hear frequently, either from defenders of the industry or people who have allocated clients to the industry. Okay, here's the first one. Isn't it true that every day or every week, a lot of these loans mature, term ends, and the money is paid back without an issue? Or there's some mechanism by which there is a workout between the fund and the borrower and nothing yet other than the frauds, which we know about, which were last year so far.

13:23I'm sure there are more, but the ones that we're aware of, other than those, a lot of loans mature every day and the money is paid back. A new loan is made. There's a role and it's sort of uneventful. Is that maybe part of why there's a lot of complacency still or do you view that as a legitimate pushback against this idea that everybody is insane with the way they're marking their their uh values yeah refinances are fine when there's money pouring into the asset class okay which has been the case so far as soon as recently yeah as soon as there stops being inflows it all of a sudden gets harder and people have to actually you know acknowledge the fact that these are really defaults.

14:08You wouldn't use the P word to describe that. You wouldn't go that far or you would. What is the P word? Ponzi. You know, it has characteristics. It's like, I would say more so a bubble. Okay. The second sort of devil's advocate comment would be, if this is true, why aren't institutional investors pushing back harder on these marks? If it's as obvious, If it's as obvious as you make it sound, which it may be, where is the pushback from the larger end investors? Forget about wealth management because a lot of these deals obviously have institutional money in them as well. Yeah. I mean, where was the pushback in 2007, 2008?

14:57So it's in everyone's best interest to not push back, in other words. Yeah. Everyone's making money, right? And then every single time, you're expecting it to never end. The banks, why aren't they pushing back? Because they make more money on this business segment, specifically direct lending, than any other business. That's where all of their growth, as well as the highest margins that they have are. Right. But you have you've pointed out something that I think is really important, which is that the liquidity, the quote unquote liquidity in this system, this particular system is more manufactured than it is organic.

15:39And when inbound cash slows down or, God forbid, reverses, I think the reliance on finding new sources of capital becomes more of a spotlight issue. And maybe this is about ongoing capital commitments. You've written about certain funds where it's unclear where they're even going to get the money to fund the existing commitments, let alone if something goes wrong and there's some sort of a hole. How much of a worry is that component of it? Structurally, it's a huge issue. I mean, these guys are allergic to cash drag. They want to get, you know, for these unfunded commitments. They want to get that few million dollars now so that they can loan it out.

16:24You know, they're running with zero margin of error. And they say, oh, well, we got, you know, Cliffwater specifically said they had two years of liquidity with no inflows. They didn't count the unfunded commitments. They are contractually obligated to fund. Right. So there's money they have to come up with for existing commitments that, and it's, I think it's in the billions for a lot of these funds. Okay. Oh, yeah. Last week, we heard from Blue Owl, and the headline that got everyone's attention was the fact that they had, for one of their funds in particular, almost a 41 % withdrawal or redemption request.

17:14but if you read a little bit further down they say the redemption requests are coming from only a small number of investors i think they said less than 10 they also said that they had uh actual inflows to go along with all those outflows what do you what do you make of that because the defenders of the asset class rightfully pointed out hey look there's actually still people writing checks and bringing in investment capital, even though there's a lot of demand to withdraw. Yeah, Cliffwater said the same thing. They predicted$3 billion coming in, and they're backed by Temesek and TPG. So maybe they get bailed out.

17:57I would really think about that. So if a small contingent of super high net worth people are the ones redeeming, and it's only you know the panic hasn't started you know right like if if the smart money is getting out in big check size and they're saying oh it's just the smart money that's really small contingent it's like uh we're just getting started is that the smart money the 10 that's redeeming versus the 90 that's staying put do we know for sure that that's the smart money because i think the industry would say, actually, that's the panicky money where the financial advisors who placed their clients in this fund did not do a good job of explaining the illiquidity.

18:44Yeah, go on Twitter and see the people defending this. They're not the smart money, okay? Okay. The people leaving, game theory says that's intelligent. If you go out of these funds at NAV, first of all, they're going to sell the best assets first. The more assets they sell, the worse the NAV gets, right? They're going to window dress. There's only so far that they can do that. The game theory is, even if you like private credit, you're going to go into these BDCs at a discount, which are closed funds. Okay, so let's pause there so we can explain that. You mentioned there's a lot of crossover, so you might have a private credit product that does not trade.

19:28It might have as much as 80 % overlap with a sister product that is publicly traded, what we call a public BDC. And it's got a ticker symbol. It goes up and down each day like a stock or an ETF. The public version for a lot of these is at a 20 % or 25 % discount to the stated NAV or net asset value of the portfolio. If you own the private version, they are marking these things at what you consider to be an inflated NAV. If you go into the public market, you can buy that at a 20 % discount. Even if you don't believe the marks, it still sounds like it's a better use of fresh capital to the sector.

20:14You, what explains the behavior of somebody that would rather have the private version at the inflated NAV rather than by the publicly traded? Are they that averse to the daily volatility? Yeah, I think that's a component of it. But I also think that there's, if we don't move, there can't be a problem. I think there's complete delusion. If you're going from B-Cred, Blackstone's got maybe$300 billion of REA money in it now. If you're going from B-Cred to BXSL, which is at a 12 % discount, it's 80 % the same loans. Everyone should learn how to use Claude. Go say, match the loans. How much of a difference is there?

21:03This is the same credit team underwriting the same loans. And then even if you don't have a direct match, because for whatever reason, you're in TPG or something like that, these are broadly – they're all the same companies. The borrowing companies in the portfolio, the portcos are almost all the same. You'll see the same companies everywhere. And these guys want to say it's salesmanship. right? We're really good underwriters. There might be problems elsewhere, but we're the best. It's like, they all say that. They can't all be the best. There are definitely guys that are way worse, but they all rushed into the same...

21:54BlackRock is considered pretty well. They're all trying to deploy so much capital. Cliffwater is deploying. They have 20 or 30 credit guys. First of all, they don't underwrite, but just do the math on how many credit guys they have and how much capital they're deploying. It cannot be super intelligent. It's almost like buying HYG. They're just putting money to work. And these are, for each loan, 350-page loan documents. And then you've got to go through the models and you've got to do all of this. the amount of deals that they're doing, they're not reading the contracts. They're not reading. There's just no way mathematically or logically you can trust that the underwriting is clean and pure, even for the best.

22:48I want to give people a sense of how big this is. You've said that the leverage in this system is much higher than people realize because it's embedded. It's not just in the fund, but it's at the borrower level. What are the stats or what is the idea of the true leverage in the system that rings alarm bells for you? If you're thinking about a business or economic outcome and considering that a base unit, and then you have hopefully 25 % EBITDA margins. And by the way, I want to cut in real quick. Please. Everyone should go look at Dom and Doran's table for how to rate a bond based off of size, based off of he used EBIT, right?

23:42He's got coverage and he's got EBIT. They want to throw away the DNA and add back a bunch of other stuff. So, you know, when they say it's a triple B rated investment grade bond, try to convert that to what Dom and Doran would say. and then they package it all up in a double a clo so it's the same thing that happened in 2008 that's uh nyu professor quote uh quote the dean evaluation uh demotoran so uh okay all right so but like how i guess i what i'm trying to get to for the for the audience is um how like how much leverage is out there in this system and and how dangerous could it be if we do get into a weaker economic environment where things start to go wrong.

24:30Just talking about the base unit, though, obviously there's operational leverage. The variability of revenue affects earnings or EBITDA at an inherent base level. And the economy, how the economy does will obviously influence that. Then they're running seven times leverage on top of that. it's really nine times if you take away their synergies that they always like to talk about that don't end up actually working. And then on the front side, you have some amount of leverage, usually 1.5 to two times. In these CLOs, depending where you are, it might be up to 10 times. So just you're not getting 10 % because it's a corporate IG bond and it's safe.

25:21And, you know, just understand. You're saying the end investor is getting 10 % as their annualized return, let's say, through the interest rate. But there is a lot of leverage that's baked into the cake in order to deliver that 10%. For sure. And obviously risk associated with that. Of course. Where that goes into the system is a whole different equation. Because a lot of people are probably watching this and they're like, eh, I always thought that was kind of weird and dumb, but everyone's telling me it's not systemic. Okay. But of course it is. Because if everyone's doing it, by definition, it has to be systemic.

26:03Yeah. I want to highlight the number you opened with. $10 trillion is on the balance sheet of US annuity and life insurers. Okay. These are huge numbers. The Fed balance sheet is six point something trillion. Okay. This is a bigger balance sheet than the Federal Reserve that everyone wants to trust that they can permanently bail out everything forever. So that's where I wanted to go next. And this is where for me, because I'm reading all your stuff. And so you write an open letter to Treasury Secretary Besant. And then you followed that up shortly afterward with an open letter to Representative Johnson in Congress, who I guess has insurance company oversight.

26:48Is that the only way this changes is through Congress? You know, I got to speak to the Speaker of the House. Okay. So basically what you're saying now is that this risk does not stay in the private funds. Meaning think about all the people who are watching this or listening to this. They're saying to themselves, well, I didn't invest in any of these private BDCs. I didn't invest in the public ones. I don't even know what these things are. They're not in my portfolio. I'm a Vanguard investor. I'm an iShares investor. I don't give a shit. Now, you're saying this is a life insurance industry issue, which absolutely could come home to roost and affect people in the same way that the AIGs of the world were affected.

27:36And that development where people saw the connection between the stuff that Goldman Sachs was buying from AIG, the liabilities that AIG was incurring for selling these products, that's really when the financial panic went into overdrive and they had to pass TARP because they recognized, okay, this is not about speculation anymore. This is now about the insurance industry. And I don't want to alarm people unnecessarily, but you are worried about this and you are calling attention to this because you do think that it could threaten the insurance industry or force a bailout of some kind. So could you tell us in the time that we have left why insurance is where the rubber meets the road?

28:22Yeah, that's where the mass of the issue is. for the A &L, annuity and life industry, they have$658 billion as capital surplus. That means that their assets and their liabilities, both a little bit over$10 trillion, $9.5 trillion, the difference between that is where it goes to the government. okay that means that they're on average levered 17 times lehman was levered 30 times right before bankruptcy right there's there's obviously a lot of uh discrepancy where you know the pe backed insurers are being extremely aggressive the pubcos are being almost as aggressive and the mutuals are much better you know if you have a life insurance policy from New York Life or some other mutual fund, it's better because their incentive is to you.

29:23You are an owner of the Green Bay Packers when you have a policy. The incentive structure is far better. The$600 billion gap, that's where it's like the industry wants to say we only have 8 % exposure to private credit. Okay. But you only have 6 % before receivership for the entire industry. And obviously, when there's a credit crisis, it doesn't happen just in private credit. It's going to happen in all these different silos and buckets. We're already seeing high yield and high quality corporates start to grow a spread. So, you know, you have extreme risk takers in there. And that's kind of just the overview of the math.

30:10Then we need to look into the mechanics, which I've done with a forensic accountant who has been screaming about this for 41 years. he's been chasing down fraud in the industry. And there are seven reinsurers that 680 different life insurers are saying, okay, well, in annuity in life, our biggest risk is our balance sheet. In property and casualty, it might be hurricane risk or fire or what have you. So they will reinsure the risk of their balance sheet to these guys. And it's a put option. But the thing is, the seven don't have the money. So then it goes into offshore and they say they have$2 trillion backing there.

31:02I think we're lucky if they have$1 trillion backing there. So then when you have a hole. And, you know, by the way, TARP was, the headline number was 700 billion. They only drew 450-ish billion, and that took down the entire global economy, right? So there's something like that. And it's like, oh, well, the Fed will just print money and it will go there. It's like, if we don't address it, and that's why I'm going at this from like, can we just look into this, please please and this has all been regulated where u.s regulators are not allowed to see what's in the bermudas whatever lobbyists decided that they were going to convince politicians that it's okay that we have to trust offshore accounts is it doesn't make any sense we need to bring it back.