Author: the_red_deer

Consider this part 2, with part 1 being a prior post titled “Kings Don’t Buy Flow.” If you have not read that, it is likely worthwhile to do so for this as this picks up where the prior article left off.

If insurance asset management at its core is indeed a low quality revenue stream due to low fees and little / no carry, requires multiples of traditional fee + carry AUM to make meaningful fees, and is potentially is best served by vertically integrating credit origination across both large credits and myriad smaller credits – one naturally would want to know if there are ways to upgrade that quality of revenue and reduce the capital intensity, at the expense of further complexity.

Like most things in investing, one can take a high-octane approach or a conservative, measured approach. In a simple applied example, to achieve certain investment outcomes, one can utilize leverage to turbocharge returns at the risk of ruin or use no leverage and take longer to reach the destination with lower risk of ruin. 

Leverage truly is a double-edged sword. But sometimes leverage can be a bit of a gift, with the right terms. Margin lending is a widely available form of leverage and easy to access, but subject to public market sentiment. Leverage in the form of corporate bank loans and bonds is frequently used by corporations but subject to covenants based on fundamental performance metrics. A US home mortgage is an example of a truly special kind of leverage, with no recourse to the borrower, an astounding 30-year term, and no mark to market margin calls nor any real covenants. 

But there is one form of leverage that is truly special. And that is the leverage provided to an asset manager by limited partners. Only in this truly special relationship does one party effectively get massive leverage, with no immediate recourse or financial penalty, and that same party gets paid fees to take on the leverage. Now I know I am slightly misrepresenting the asset manager / investor relationship in relation to the word “leverage” – the investor has equity upside, not a debt-like upside which is capped in theory. But the management fee + carry business model is a true thing of beauty for its ability to rake mountains of cash to the asset manager if investment performance activates dramatic amounts of carry, with low capital intensity.

Now back to the prior topic: you are an asset manager trying to win in insurance. The fees that the pure play private investment grade asset management business generate are low. So, what can you do? You may ask yourself whether there are pockets of equity that exist in your structure in which a fee + carry approach may be able to slot in. In this case, a winning strategy is the shaking your box of insurance asset management so vigorously such that any part of the structure that qualifies as equity falls out the bottom. And for every crumb that falls out, you whack a management fee + carry model on it to drive higher leverage in the system, and upgrade the quality of the consolidated revenue stream within insurance asset management.

Remember, if you want to be a king by not buying your flow, this monarchial effort is an equity intensive endeavor. I established in the prior post that to fund the vertical integration of your insurer, capitalize specialty finance companies, and provide capital for their growth – a substantial initial and material ongoing equity commitment are required. But on the bright side, the sleeves of equity that fall out when that when the proverbial box is shaken, can each provide opportunity to apply a fee + carry model on top.

Equity Sleeve #1: Insurance first-loss capital 

All that have taken insurance liabilities on balance sheet are either considering or have already taken on positive leverage in the form of other people’s money to fund growth in their liabilities / annuity book. Every annuity policy requires some reserves placed against the policy to make whole the annuitant against guarantees issued. For the privilege of providing the first loss capital, the person that puts up the reserves receives the spread that the portfolio generates in excess to what the insurer guaranteed the annuitant. Given the cash generative nature of the annuity, co-investing in this sleeve was an especially interesting product for limited partners in a zero-interest rate environment. However, “sidecar” capital to fund liabilities has continue to proliferate in a higher for longer environment. These sidecars pay fees to the asset manager in the form of both asset management fees and the almighty carry, as the return is an equity return and can bear high quality, equity-level fees. 

Equity Sleeve #2: Specialty Finance Companies 

Another place asset managers can introduce carry and reduce capital intensity is in their specialty credit origination machines. They can bring in other people’s money to participate in the equity layer, and again given equity-like returns, accrue both fees and carry. This can reduce the burden of the capital outlay required to build your flow in exchange for increasing complexity to investors in the top Holdco. People that make such equity investments often also want access to the flow that the specialty finance machine creates, so it is a bit like a “pay to get access to your pro-rata share of flow” arrangement. 

Asset managers will utilize positive leverage in both of those pathways (insurance liability sidecars and specialty finance equity) to help lighten the capital burden to be successful in insurance.  

Equity Sleeve #3: Insurance Balance Sheet Equity 

There is one more pocket within the supply chain in which more leverage can be added, though this is more akin to traditional leverage versus the positive leverage offered via the fee + carry model. What if you could take equity capital, leverage it 10x, and then use 5% of the total leveraged capital to fund your specialty finance commitments. Said differently, if you vertically integrate your insurer using $10 of equity capital, and that allows you to manage $100 of assets, and you could take $5 of those assets to invest in building your credit flow pipeline (if you choose to invest all of it in specialty finance companies). The alternative is funding those specialty finance equity commitments from your Holdco balance sheet. 

Effectively, if this pathway is chosen, one is funding the capex necessary to build their own flow by using other people’s money in the form of the annuitants’ reserves. And while, as mentioned, this is more akin to traditional leverage in a sense, it enables further fee + carry applications.

Equity Sleeve #4: Insurance Equity Portfolio Co-Invest 

Specifically, utilizing the equity sleeve of the insurer’s balance sheet to fund specialty finance equity investments enables a co-invest opportunity with a fee + carry model. Remember, we now considered that the specialty finance portfolio can be funded by 5% of the insurance portfolio. That is to say, the 5% insurance balance sheet driven investment is paired with positive leverage, say 70% insurance company money and 30% other people’s money. 

In summary with this model, you have the following: $5 in insurance company equity paired with $5 in sidecar equity supports $5 in insurance company equity assets. $5 in insurance company equity assets supports a ~$7 evergreen fund (70/30 split). A $7 evergreen fund supports $14 in specialty finance company equity (50/50). So, $5 in equity drove $14 in equity investments. Last, consider if inflows from new insurance liabilities grow the business 10%, requiring $0.5 in incremental statutory insurance capital. If all OPM commitments grow in line, $1.7 in additional specialty finance equity capacity is created. Keep in mind that the specialty finance companies if performing well (not to mention the insurer), generate material amounts of cash to support equity growth. 

The overall point here is that the ownership of an insurance company can enable an asset manager to reduce the capex commitment required to generate one’s own flow. Moreover, the leverage in the insurance company makes every dollar of growth in the insurer generate a multiple of equity capital to invest, further multiplied by introduction of incremental OPM at every stop in the value chain. This leveraged approach makes it incredibly hard for players not pursuing this model to simply keep pace with the quantum of capital being sunk into building flow. 

Back in the real world, those numbers I walked through were taken to the extreme for illustrative purposes as the insurance company will not allocate the full $5 in balance sheet equity to specialty finance. Moreover, insurance liabilities in the ground today are not split 50/50 between asset manager equity and sidecar equity, as sidecars are newer to market and fund recent and future growth. But hopefully this helps illustrate the idea that this model is akin to 8 person shell rowing versus a 1-2 person shell (I never rowed, pardon the lack of correct rowing verbiage).

Equity Sleeve #5: Up The Value Chain (Warehouse Lending) 

What if, to further increase the aperture of where one can generate flow, the asset manager goes up the value chain in specialty finance? It not only builds its flow by owning and running specialty finance companies but starts to play bank by financing 3rd party specialty finance companies, thereby generating high quality credit via warehouse facilities and gaining access to the desirable IG tranches of the ultimate securitized product. And again, funding this from the insurance balance sheet / evergreen fund.

This strategy of using OPM in every part of the system multiplies the capex availability to form credit, enabling it to extend its reach substantially deeper into the broad industry of investment grade lending than a strategy using greater own capital. It is extracting flow from places that a capital light approach likely cannot begin to touch. Its reach up the value chain also places it at the forefront of specialty finance M&A (though in theory there is a firewall between a warehouse lending group and the broader asset management and insurance practice).

The opposite approach of originating solely within corporate and real estate debt and buying flow in other large sub-sectors of credit (e.g., consumer, student loan, credit card) and depending on the business quality of insurance clients to drive growth in their liabilities to grow one’s own AUM, obviously seems like a less committed or a more hedged approach. Simply focus on capturing some of the retirement tailwinds, driving greater scale in corporate and real estate lending, and innovating more capital light ways to expand. And most important, avoid incorporating insurance liabilities and ALM management, maintaining simplicity in the business model.

Moreover, adding the higher octane gas to a business model in the form of taking the insurer on balance sheet and stuffing any existing equity sleeve with OPM creates a daisy chain of interdependencies. Leverage in the form of equity capital from others, even from sovereigns, may be finicky during the worst of times. And a model that incorporates OPM across one value chain versus a model in which OPM is deployed mostly in unrelated silos is likely more fragile.

Only time will tell which model(s) within the “build flow” approach will win, or whether the “buy flow” approach has winning legs under it. However when within asset management, the term “insurance” as a growth vector is thrown around as if all approaches are relatively analogous with respect to the model employed, addressable size, quality of revenue, capital employed, and investment pace – it is worthwhile to explore just how different they are.

Note: This post is general commentary, there’s no moneymaker stock pick in here. I just like thinking about life insurance / annuities. I also did not spell check this.

About 10 years ago, I remember being in a smelly conference room full of MBB consultants and PE clients discussing the output to the question posed to us – what is Apollo up to with Athene? While there was not much else insightful about that moment to mention today, I do distinctly remember the point person of the PE client’s response when the partner on our team described the 5 years Apollo had been at this as a potential barrier to entry. The guy was rather apoplectic and growled, “Are you fucking telling me you don’t think we can do this? Do you think we’re fucking incapable of executing something like this?”

All told, the guy was probably just having a bad day, but they did go on to try, and by most measures, did not succeed given their head start. If you asked me then, 10 years ago, if the project that we worked on (life insurance) would be perhaps one of the hottest things in asset management 10 years later (perhaps second only to private credit) – I simply wouldn’t have been able to conceive how that would come to be. Yet here we are.

If you’re unfamiliar with the space, Life Insurance, or more specifically the Annuities part of “Life and Annuities,” has undergone an evolution in which the collision of Dodd-Frank fueled separation of myriad lending activities paired with both the previously sleepy long-duration reserves of an annuity contract and the need by legacy annuity writers to unload unhealthy blocks. You see, the legacy players wrote annuities during a time of normal interest rates pre-2008. As rates pressed down to zero, the underwriting assumptions floated farther away from the reality on the ground. Annuitants didn’t let go of their annuities because what were they to do, roll them into new near zero yield new contracts? The asset-liability mismatch ensued, and these blocks were stuck with stubborn liabilities paired with near-zero yields in the assets they were allowed to invest in by law.

Apollo was not the only one active, but perhaps the only one doing size in relieving these legacy players of these capital-intensive and unprofitable books of business. Sellers were able to release capital to reinvest in more profitable business, and the buyer got a block of annuity liabilities cheap. Pair that with a generally fearful credit environment, and strong profits ensued for Apollo.

Fast forward to 2019, people in the KKR and Ares lab must have had a similar “what is up with Athene?” moment, as Apollo had quietly scaled Athene up to well over $100B in AUM at the time and had gotten traction selling annuities to retail via its acquisition of Aviva’s US annuity business. The conclusion of their hypothetical lab moments was an exhausting diligence between KKR and Global Atlantic, an annuity writer incubated and owned by GSAM clients, during the outbreak of Covid. The result was an announcement of majority ownership by KKR. Ares followed with the purchase of a tiny outfit to be used as the chassis for a de-novo effort. I believe this was when the rest of the “pack” took notice and the stampede to establish a beachhead in life insurance started in earnest.

Today, Brookfield has acquired its way to $100B in various diverse liabilities extending beyond annuities. Blackstone has taken an “open architecture” approach by partnering as a 3rd party manager to other insurers’ balance sheets without permanent stock ownership of an insurer. Mutuals are establishing beachheads to reinsure the tidal wave of annuities from other mutuals. Sidecar funding to fuel the capital requirements of steep annuity writing growth is gushing in.

So where do we go from here? This open-ended question can take various different pathways, but I’m personally interested in the following question. While “insurance” is mentioned ad-nauseam in all external-facing press across asset managers, who has the best setup?

First, it’s helpful to understand where each player is playing, roughly speaking. I don’t include all players because (1) I don’t know all well enough and (2) some are just less relevant.

Profitability on the “complex” side of liabilities is more dependent, on a relative basis, on underwriting based profit versus the “simple” side. Said differently, investment results matter more for simple liabilities versus complex liabilities. This is why asset managers tend to focus on the simple liabilities in their hunt for more assets to manage. Thus if you have the means to do so, you likely push from the bottom right to the top right if you can, as the bottom right (acquisition of simple blocks) is very crowded today.

Athene has all but vacated the inorganic field and focused on scaling simple liabilities up and above the pack while KKR has pushed into a niche of very large but complex reinsurance deals (e.g., Long term care with all non-spread risks reinsured to 3rd parties). Ares is ramping up its issuance of organic business and Blue Owl has acquired the old Allstate life business (most recently owned by RenRe) which has an organic pipe.

Brookfield has acquired American National, Argo, and American Equity Life in a very short period of time (in insurance years). My take on their approach is they got in a room one day and had a decision to make. Should we start this from scratch and be a cautious and slow late mover (Ares approach)? We’ll have the benefit of a unified technology and support stack, have no dirty back-book of liabilities, and build our IG private credit business in tandem. Or should we put this together inorganically, thereby prioritizing getting to scale quickly while sacrificing the above benefits and short / medium term returns (if all goes to plan). My guess is the thesis that life insurance as an industry may grow well in excess of what people believe held the day, so getting to scale to capture a greater share of the future growth is more important than having the cleanest base or great day 1 returns to start with. While I’m quick to clown Brookfield as the difficulty of dealing with all sorts of legacy liabilities, 3 different platforms, and doing the same on the private IG asset sourcing side of things, I have to be open to the fact that they have considered this and feel good about the work ahead. Time will tell.

Fortitude (Carlyle) has taken an opposite approach by consuming large inorganic blocks of complex liabilities. It likely believes that in this less competitive market (likely by a wide margin), they can get pricing that more than compensates for the thorny and terrifying nature of the liabilities. Actuarial risks aside, many of the liabilities that they are purchasing are very long duration and provide for a long runway of investment on the asset side. But the attraction of long duration liabilities and the ability to invest them to earn fees is a side show to the main event of pricing the insurance risks correctly. Time will tell whether this very insurance risk centric approach is fruitful and synergistic to Carlyle’s asset management business.

The Big Picture

Major point one of this missive: (A) revenue derived from managing 3rd party insurers’ assets is a low quality revenue stream. Consider 2/20 over an 8% pref, or 1.25/12.5 over a 5% pref. How much AUM do you need to manage to be a legitimate growth engine versus your higher margin fee cards at 40bps and no carry? A ton. And you only manage the private IG part of the insurer’s balance sheet, not the whole thing. So you need a lot of very large clients who are growing nicely. And the list of potential US clients isn’t that long:

If…you want to manage a metric f*ckton of insurance assets, (B) you need a gigantic amount of flow. Private IG credit is relatively short duration, say 4 years. So a huge portion of your client’s assets are rolling off each year and need to be replaced. And if you have growth ambition, well you need even more flow.

Asset Manager Approaches to Flow

Asset managers have taken differing approaches on how to deploy their insurance strategy. Namely, some firms have essentially vertically integrated insurers into their business. Others just serve insurers as clients like they do clients in other asset classes. Each argues their model is superior yet it’s unclear whether there’s truly a right or wrong.

Few Large Trades and Flow Deals

Let’s say you want to source some multi billion dollar amount of private investment grade assets every year. How do you do this?

There are two pathways. One is to underwrite a small volume of very large transactions, which can be parceled out to insurance clients. In contrast, the opposite approach is to underwrite an immense amount of small(er) ticket loans and aggregate them.

In the first pathway one may get two Patagonia vests and a Bloomberg and have them buy BSLs, package and tranche them up, have your banker sell the AAA/AA pieces to Japan, parcel the A/BBB tranches to your insurance clients, and stuff the mezzanine tranches in a captive vehicle with 3rd party capital / sell it off. That works to some extent, but insurers need diversification, so you need more than just structured corporate loans.

Maybe you lift out a team from a bank consisting of 30 vests and 30 Bloombergs and you’re in business making commercial mortgage loans. Pretty good! But in each of these oversimplified examples, there is high competition given the lower barriers to entry and what you effectively get is beta plus an illiquidity premium.

But corporates and mortgage loans don’t provide your insurance clients with enough diversification, so you have to figure out how to get access to various other specialty finance end markets – such as consumer, equipment leasing, railcar leasing, etc.

The Flow Purchase Approach

One can choose to build specialty finance vehicles to diversify their flows, or they can buy the flow from others and place it with their insurance clients. Like Costco but for IG private assets, “we buy in bulk for all of our clients and get deals you can get due to the size we’re buying.” They look at the bank and non-bank specialty finance landscape from large cap to regional and say to themselves, these people have all the technology, systems, and relationships in place already. Why build something that dilutes my core business when not only do they have everything in place, but they need capital to relieve their balance sheets – perhaps forever given the trajectory of regulations. Blackstone has done forward flow agreements with Barclays and Keycorp, who are likely more than happy to preserve the front end relationships and collect fees while relieving their balance sheets of tied up capital. Synthetic risk transfers of bank assets have also come en vogue to further lighten up bank balance sheets. Ares has been aggressive here. Before, these wouldn’t be as interesting to asset managers given the low absolute returns but their insurance clients provide a newfound thirst for IG returns.

Overall, I believe that the flow purchase approach is generally a decent one but cedes control to the flow partner on the credit pen, volume, and technology / support standards backing the business. Moreover it can be somewhat pro cyclical as independent speciality finance businesses are generally writing more business during good times and hunkering down during bad times.

Last, if we consider episodic purchasing of assets from banks, there are limits on future visibility of what the asset managers can feed their insurance CIO clients. There is a material advantage to be able to forward plan what is going onto an insurance balance sheet as the insurer can be sure not to over / under produce liabilities, take on other assets at the right time, and ensure diversification.

Aggregation of Small Loans

Consider Ricoh Imaging, an office printing equipment lessor and servicer. They supply offices with various imaging devices and handle resupply / maintenance so that corporations don’t have to dedicate headcount to such activities (sidetone: one of my high school jobs was refilling paper and ink at a HP office). In this case, GE Capital was the longtime financing partner in this space to Ricoh, providing the financing for printers, imaging devices, etc. The ticket size was undoubtedly small. It required a technology and support build that takes time, money, and brain damage. 10+ years ago GE Capital had well north of 200 people exclusively selling, underwriting, and servicing Ricoh vendor finance. This is not a screen based effort, nor a call around effort, it often requires an on the ground, high headcount sales presence that is pressing flesh. And those relationships matter. GE Capital’s relationship with the maker of Yale forklifts was north of 20 years, its relationship with Bobcat mini-dozers was over 40 years. And Ricoh, Yale, and Bobcat are just a few of the countless GE Capital clients that followed the mold of aggregating medium / small sized tickets. But perhaps most important, these businesses are not easy to scale. You could very reasonably have the 10 vests originating CLOs, 50 vests doing CMLs and 250 person specialty finance company, all originating $1B in credit annually. As a more tangible example, OneMain Financial has near 10k employees to originate about $10B / year in small ticket personal loans. Then there’s a wholly separate piece to consider standing up a specialty finance operation.

So you wanna to finance Yale forklifts? You invest in building the tech and support necessary to underwrite / ingest small ticket loans and somehow you start stealing business from an incumbent and start piling up loans that may be interesting to your insurer clients. But wait, not so fast, they don’t want first loss risk. First, you need enough scale to be able to securitize the loans and create a large IG tranche. It doesn’t work at small size. And you need someone else who will take the first loss layer. Are there natural buyers of specialty finance equity layers? Probably some. Clearly markets exist for corporate / real estate junior tranches but for your niche printer leasing equity layer? Maybe not. Moreover, you want to have a dependable buyer for that risky slice of paper that’s there for you during both exuberance and desperation. Realistically you need to have a vehicle that warehouses those equity or junior debt slices to always have a buyer of last resort. So not only do you need to build the systems and human capital to sell, underwrite, service small ticket loans, but you need to put up reserves against your equity layers (or at least whatever portion of those layers the banks won’t finance). Congrats, you have effectively created a full blown corporation called a specialty finance company.

How to Pay for Specialty Finance Companies

If you’re standing up your little CLO squad, you probably don’t need much capital (ignoring risk retention regs for now). Especially if you’re able to sell off your equity layers. You just need to hire a few people and pay their salary until the fees start rolling in. Effectively you’re standing up a capital markets effort, something notoriously asset light.

If you’re standing up a bonafide specialty finance company, it costs dramatically more. Both KKR and Apollo have either bought or built a specialty finance portfolio that have required somewhere between $5-10B in equity capital to date to fund. Within these platforms Apollo has roughly 4k employees, KKR has 6k employees, and as a reference point, GE Capital had well north of 22k employees executing their commercial loans and leases segment (equipment leases, ABL / factoring, leveraged loans, franchise loans, inventory finance).

The issue with sinking all of this capital and complexity into specialty finance shops to fund your private IG asset flow for insurance clients is it probably doesn’t pencil if you’re just clipping 40bps as a manager of 3rd party assets. (C) There’s a reason only the asset managers who brought the insurance earnings on balance sheet are pursuing this strategy, as the insurer provides the capital required. Said more directly, you need to own an insurer to the strategy of directly running a speciality finance portfolio to feed your flow needs. And accordingly, you need to accept that you are forced to (1) compete with your insurance clients as well as (2) take on insurance risks, however large or small.

Which Model Is Best Positioned?

Separate from which asset manager will either grow fastest overall or have the best stock performance, I’m interested in thinking about which asset manager is most successful in the insurance space.

To summarize the vectors discussed:

• Given the low fee rate, the amount of insurance AUM you need to manage is massive versus legacy alternatives products (that have higher fee and include carry)
• To manage a massive amount of insurance AUM, you need massive flow, which you can either gather via fewer large trades and flow agreements or the aggregation of countless small loans
• Fewer large trades require less capital and complexity whereas small ticket aggregation requires a lot more capital and complexity / execution
• Fewer large trades / flow agreements involve better line of sight by virtue of smaller operations, access to flow partners that are at scale
• Small ticket aggregation is a supposed pathway to higher returns by virtue of diversification, lower fee drag, less competition, control of credit pen, and less cyclicality
• The cost of full corporate infrastructure and equity capitalization for small ticket aggregation versus the thin fee rate of insurance AUM only makes this possible for those that have the insurance earnings or balance sheet to shoulder the cost of this

The other vector I’ll introduce, albeit near the end of this note, is given the above graphic of how concentration of annuity assets exists (top 20 players are roughly 75% of annuity origination), and that concentration is increasing quickly, the competitive positioning of your insurance partners will matter more going forward than it did in the past. In the past, it was really a race to see who could pair up with whom (or merge) and AUM allocated to alts grew quickly.

So which model on the back of this does the best?

Frankly I’m a bit tired of writing this piece, have re-written the end many times, and find it not hitting the spot. So I’ll leave this note with the following, which is what I believe to be true, and you can draw your own conclusions.

Kings don’t buy flow.

As the prior higher inflation prints are lapped, expected future inflation chart looks more visually settling:

While much ink is spilled about every change in inflation expectations, 10 year expectations are comfortably below 3%. We’ll see if that is the reality we experience in light of a very hot economy in 2024.

Investment income for the quarter was down 8% vs the prior year, a trend we will see throughout this year due to one time catch up dividends issued in 2023 along with sales of investments that currently sit in cash. For the full year I’m projecting investment income to be down 10%.

However, on a two year basis (2023-2024), 1Q24 income is projected to be up 22% or 10.5% annualized. I’m projecting investment income to be 12.5% from the start of 2023 to the end of 2024 or ~6% annualized over two years.

Inflation was ~2.8% in 2023 (PCE), and the Federal Reserve expects it to average 2.4% in 2024 – so roughly 2.6% annualized. Our ~6% expected annualized income increase thus theoretically provides a respectable 3.4% real return over these two years.

On a more granular basis, NAV was up materially, reducing the yield of the portfolio. While paper mark-ups feel nice, anchoring to income provides a more sober view of performance. Moreover, we had one loss that was crystallized in 1Q24 that was particularly painful.

We owned a complicated financial company of which the simple thesis was that there would be a cyclical recovery in M&A volumes. That has indeed started happening but unfortunately this is was not the vessel with which I should have expressed this view. The company took on accounting related issues and became a magnet for short selling. While unforeseen downside events are a part of investing, not moving on immediately when the situation shifted well outside my narrow lane of competence was a mistake. While this was not a large core position, any loss hurts and I aim to not repeat the same mistake in the future.

Separately and unrelated, we have had multiple publicly traded BDC positions return to NAV from a discount position. We also own two positions in privately traded debt funds that mark holdings at their (theoretically 3rd party verified) NAV each quarter. One thing I’ve been pondering is whether during times like these when publicly traded BDCs are trading at or above NAV, is to hold mostly private versions and then to swap for public versions during drawdowns in public markets. In theory, these assets are similar and in some cases the same underlying loans, but private funds are slow to mark down their holdings or outright disagree with public marks and refuse to mark down. A small tactical thought but one I’m chewing on.

Looking forward, we have a modest cash position due to a lack of ideas and the sales of a few investments. Thankfully, a high relative return on cash keeps me away from reaching and I’m near certain that time will offer up interesting opportunities to get fully invested again. Happy hunting.

Spending time around trading markets, measured in decades, results in very occasionally making “blink” speed investment decisions (a term I came across on another blog).

In a prior post, House of Brindle, I mentioned how I had followed the career of Richard Brindle over the past decade. I owned stock in his prior vehicle, Lancashire, before he moved on and started Fidelis with private ownership. Every now and again I would collect all of the updated news on him in hopes of finding out when he would bring a vehicle to the public market again.

That happened in 2022 with the vehicle going public in 2023. I read the prospectus and presumed the vehicle would trade at a rich price given his track record. When the IPO busted I looked closer and was turned off by the heavy fee structure Brindle extracts from the public vehicle. But after the share price took a further dive post 3Q23 earnings, I dug further and concluded that the discount was too much. I outlined the following highly complex, nuanced, and detailed investment thesis (I kid):

The reasons one invests in FIG are simple. You believe that Brindle cares about FIG’s success, will write good paper, and pass on bad paper. You believe that there may be an extended hard market. You believe that he will return capital when things get soft. And last, you believe you’re getting compensated for the fee arrangement through purchase at 65% of book value. That’s it.

65% of book value was ~$12 / share, where the shares were trading in December. The simple math was book value was $18.50 and a 13% ROE (low point of their guidance) was $2.40 / share in earnings. A 20% earnings yield on a $12 stock if one believes that the business isn’t a melting ice cube. Pair that with structural reasons why others may not be able to own the stock today including recent IPO / low time in market, high fee structure, new corporate structure (MGU / Balance Sheet separation), and odd Q3 premium drop. While I didn’t make a knee jerk / “blink” investment decision, it wasn’t an overly complex investment decision and I sized us up within one month.

Fast forward only a few short months to today, FIHL / FIG released Q4-23 numbers which included a 13% increase in book value over the three month Q4 period, $1.15 / share in adj. earnings for Q4 alone, a 23% ROE for Q4, and guidance for similar premium growth in core segments for 2024 when compared to 2023. Book value sailed higher to roughly $20.50 / share. All good things.

Accordingly, the shares popped to ~$18 / share, which equates to roughly 87% of the latest book value. Profit guidance was upped to a 14-16% ROE, so to do the math again, a 14% ROE equates to roughly $2.87 / share in earnings on an $18 stock, a ~16% earnings yield (vs a 20% earnings yield in December).

While this was a quick hit, Brindle has a long history of prudent capital allocation during both soft and hard markets within the P&C space, making it a nice one to sit on and not have to think too much about going forward. One can hope that they hit their 12-15% ROE target net of fees over the long run and we have the buffer of buying at a fraction of the book value of equity.

Last, I tried to think about what lessons are learned from this scenario and I can think of two. First, aligning one’s interests with one’s investments. I’m odd in that I find insurance fascinating despite having no industry experience in the field. I probably should have worked in insurance if I had to redo my career. This interest enabled me to want to follow this guy for over a decade. Second, focusing on situations where there are barriers to ownership today that may resolve to allow greater supply of buyers in the future is probably a good thing.

One thing is certain though, lasting lessons often come from bad investments, and I have a note to pen on one of those that were crystallized recently and left a very foul taste in my mouth. More on that later.

In a prior note I penned in August, I suggested Jackson’s efforts to push regulatory change was perhaps more real and near term than one would normally assume when corporations think of government timelines.

In December the company announced that it had come to a preliminary agreement with the Michigan regulator for a new regulatory framework that would achieve the goals Jackson outlined, namely less RBC ratio volatility and less uneconomic hedge spend to defend against uneconomic RBC movements.

As the stock has not moved since the 8-K release, I thought I would put on paper what I expect the company will say with respect to the tangible outcomes for shareholders when it releases earnings this week.

Note: The below is a brain dump versus an article to capture eyeballs, so keep that in the back of your mind.

Capital Surplus

In the past, the company maintained an RBC ratio target of between 425-500%. However, it was comfortable with and often carried an RBC ratio above 500%, including when it last reported in November. Does that change with the new regulatory framework in place? I think that the company indicated as such on the prior call:

“So first on the Michigan solution, assuming you get it in early ’24, would that change how you think about your RBC target of 425 to 500%”

“I think that’s a likely outcome, Suneet, that we would want to revisit that, not indicating that how it would change. But I do think that when we set that 425% to 500% target range, we set a wider range purposefully, given the volatility in our business. And I think to the extent that some of that volatility was contributed to by the cash surrender value floor, a solution that mitigates that cash to undervalued floor solution could very well likely mean that we don’t need such a wide range to think about. And therefore, that’s something that we would be considering as we look forward and provide our outlook and targets for 2024.”

JXN 3Q22 Earnings Call

Given that the company was sitting above 500% in the prior quarter, it is not unreasonable to presume a return of something like 75 basis points (bps) of capital to shareholders (or a partial return) could be in the cards. Seventy-five basis points on total adjusted capital (TAC) of roughly $5 billion and 525% risk-based capital (RBC) would be something like $750 million, on a market cap of $4 billion.

However, I hesitate to presume anything like that will happen. If anything is clear about this management team, they have a track record of being conservative and disciplined. The odds they “stair-step” their way to an eventual resting place are very high, in my own opinion. So, say they want to likely settle on a range of 350-425% given the new framework, my guess is that they lower it to 400-475%, and then 375-450% the following year, etc.

In a different vein, the company has said it aims to maintain a minimum cash buffer of $250 million at the holding company. As of last quarter, the company had $900 million in cash equivalents and up to $1.5 billion in total assets at the holding level. Furthermore, the company generates something like $200 million per quarter, roughly speaking, in cash in the old regulatory regime, so that amount is likely higher now. So, will the company return a substantial amount of cash independent of a potential release of capital from the insurance entity?

Again, my gut feeling is likely no. The company had a target of $500 million returned to shareholders in 2023, and they were roughly at $350 million at the end of Q3. So, to get to $500 million, they roughly returned the cash they generated in Q4. But more importantly, the company is trying its hand at growing a new product category, RILA, given its distribution capabilities and differentiation of the product versus its core variable annuity (VA) product. It has grown the line of business (LOB) quickly, and if I were in the CEO’s shoes, I would consider this a “moment” in which, if the returns in RILA continue to clear a reasonable hurdle, it is a moment in time to put the foot on the gas and not be capital-limited in expanding RILA.

Call Buying

The company was buying roughly $500 million in calls in 2018 when the book was smaller and less “floored out” to the extreme. Given the book is far larger now, but more importantly, more floored out than prior, I would presume the call buying is somewhat higher than the $500 million figure. Since the uneconomic call buying may be “mitigated,” I presume this figure is now gone, a material cash saving on an annual basis. However, in the release, it also explicitly called out interest rate hedging in the new regime.

In the prior world, Jackson was clear that their hedging program was a more holistic economic approach versus a 1:1 “immunization” of macro factor risk inputs. Other insurers explicitly called out their immunization strategies to help investors focus and value the company based on the risks it is taking. With this wording, it seems, Jackson is moving closer to an immunization strategy with respect to interest rate risk. To that end, I would expect some portion of the prior call buying outlay to be utilized for rate immunization. How much? I have no informed view, and my hope that it is material is speculation. But if it does result in a net savings of around $250 million or 50% of the 2018 call buying budget, it is material against capital generation of $700-900 million per year.

Moreover, sustained annual savings are what I presume the board will overlay potential increases in returns of capital to shareholders. If cash generation increases 25% as a result of the new regime, I would presume that a material portion of this increase would apply to the dividend/buyback.

Crystal Ball

Altogether, while a more aggressive management team may initiate a one-time massive share repurchase paired with a substantial increase in returns to shareholders, I don’t think that will be the case at Jackson. I personally believe the management team prioritizes “consistency and discipline,” words that have been used ad nauseam in communications with shareholders. My best guess is the management team increases its budget for annual return of capital to shareholders from the current range of $450-$550 million to something like $550-$650 million, with guidance that any future increases in shareholder returns will continue to follow the prior framework of 40-60% of annual capital generation.

Lots of things to be thankful for in 2023 including a few special trips, good health, and a new home. 2024 is shaping up to be a fun year with winter delivering a few great days on the snow already:

On a more professional note, the inflation narrative appears to be calming down as future expectations for inflation pushing lower, down to below 2.25% over the next 10 years.

Investment income was down 1% from the prior year quarter as we lapped a major portfolio rotation in 2022 and catch up payments that were issued in 2022 disappear. While income was up 25% for the year, again mostly on the back of portfolio rotation along with some special distributions, 2024 is projected to be down 8% as these one time events are not repeated.

Furthermore, certain investments have struggled. As an example – a retail shopping center that financed itself with bridge debt with the goal of refinancing in the CMBS market never made it to the second step. Interest rate caps expired. What was previously producing $18K in annual income in 2022 reduced to $4.5K in 2023, and is projected to be $0 for 2024. Ouch. This has been balanced by others having more productive recent years.

Over the past 9 months I’ve tried to bias toward buying “duration” of income. Rather than own something like a 5yr bond that will come due soon-ish and need to be re-invested, owning equity that may have a much longer runway of earnings has been the target of my search. Moreover, while much ink has been spilled over the high absolute yield of floating rate debt, very few talk about the post-tax returns of such investments. Even fewer discuss what may happen in a recession: low fed funds rate and high defaults, both bad for these assets. Whether this bias towards equity is productive over the longer term is obviously yet to be seen.

Last, NAV changes. As expectations for inflation stabilized, equity markets rocketed higher. With that, the NAV of our public investments followed suit. But with a firm grounding in investment income, not a whole lot has changed. What I hope for in 2024 is simple: that our investments grow earnings well in excess of inflation. I believe that many of our largest investments have good potential to substantially grow their earnings, but beliefs have to turn into reality for them to mean something. In the meanwhile, we’ll just keep buying things that for some reason have fallen to an interesting price and own t-bills when I have no interesting ideas. Onward and upward.

As a younger lad, Lancashire Group was in my orbit, I believe by virtue of the Corner of Berkshire and Fairfax forum that I used to frequent back then. Lancashire was the small kingdom of a one Richard Brindle, somewhat a legend in the industry. The group followed the simple, and common strategy, of writing paper when pricing was good and the less common strategy of returning money to shareholders when pricing was bad. Brindle exited Lancashire in 2014 to “retire” and sell all his shares only to reboot publicly only six months after his non-compete expired on January 1, 2015. His reboot was named Fidelis and it stayed private for the better part of eight years, receiving equity and sidecar co-invest funding from large institutional investors.

Brindle watched and keenly understood how General Partner (GP) and MGA / MGU businesses traded versus balance sheet investors and balance sheet insurers. To get his PE investors some liquidity without selling the MGU at a discount to his perceived idea of true value, he took the balance sheet part of Fidelis public in 2023. The structure is similar to other publicly traded PE balance sheets that are externally managed by PE GPs. Think BBU, CODI, etc. The fees the balance sheet pays the MGU include ceding commissions, management fees, and carry. The publicly traded Fidelis balance sheet (called Fidelis Insurance Group or FIG) basically eats a steady diet of Brindle underwritten paper from Fidelis MGU. The MGU is also taking on other “star” underwriters by giving them a seat, capital, and admin support allowing them to focus on trading. Does this sound familiar to the pod shops that are all the rage these days? In my opinion, it rhymes.

In any case, FIG was slated to go public at book value, roughly speaking. The range was adjusted downwards as IPO conditions were rocky, appetite to pay up up for an externally managed vehicle was (and is) low, and incentives were (and are) unclear. Pricing cleared around 80c on the book value dollar with existing investors pulling out of the offering and the company was left as the only seller of about $100m in primary equity. After its second earnings report as a public company, the stock dropped to ~$12 as premium growth softened.

Its mission is 12-15% (shocker) net returns to equity (post-fee) through the cycle. Currently it is printing high teens [adjusted] ROE in the face of a very hard P&C market. The reasons one invests in FIG are simple. You believe that Brindle cares about FIG’s success, will write good paper, and pass on bad paper. You believe that there may be an extended hard market. You believe that he will return capital when things get soft. And last, you believe you’re getting compensated for the fee arrangement through purchase at 65% of book value. That’s it.

It remains to be seen if this entity can trade at a healthier multiple to book value, especially given the fee arrangement. Furthermore, there is substantial equity overhang from existing investors that likely need to get out as limited life funds near end of life. Last, while Brindle’s very direct guidance that he and the entity exist to make money above all, that includes issuing shares at FIG at a discount to book if the math on the paper pencils positive. Said differently, FIG will likely issue at 65% of book if it can price slugs of paper at sufficiently high prices.

Nothing is guaranteed. Investing is best when one’s interests cross with some form of value, and in this case, I was probably destined to own Fidelis at some point. That time came sooner than expected, time to buckle up for the ride.

Delayed post as we were fortunate to spend extended time in the sun over the past month in Costa Rica. If thinking about a trip there, Puerto Viejo was our favorite spot. Much less touristy and much more soul than locations on the west side of the country, in our opinion.

Inflation expectations have changed from the prior quarter’s summary, which shouldn’t be surprising to most:

That said, while people debate the likelihood of reaching the 2% target and the potential for changing the target to 3%, for the purposes of keeping up with or exceeding the rate of inflation – expectations of 2.5% over the long term seems manageable for now.

Investment income was up 32% over the prior year’s quarter again due to timing mismatches and reallocating to new investments. The problem child list continues to be three investments. The shopping center is essentially a poster child for getting hung on higher rates as they didn’t refinance out of their bridge in time and rate caps eventually expired. While the actual asset performs well, the balance sheet does not and only lower rates cures the equity here. The hotel is consistently struggling with retaining labor, which is not surprising, and while it continues to make distributions, it’s a shaky asset at best. Last, a financial we own has taken a major hit as it has become a lightning rod for short sellers. I won’t get into the details – but there’s a lesson here for me personally. And that is that I ignored concerns I had about the balance sheet.

Looking forward, I expect Q4 income to be down 1% from the prior year as the timing mismatches start burning off, with total annual income for 2023 up 25% from 2022. I did a quick projection of 2024, and with no increases to distributions I expect 2024 to be down 3% from 2023 as the catch up distributions we received in 2023 won’t happen again. Perhaps we end up flat to 2023 with some good fortune on distribution increases. That said, going back to the beginning of this note, the hope is that 2025 investment income materially exceeds the 2.5% inflation expectation to stave off long term degradation in purchasing power.

In Q3 I added Legal and General to the portfolio, if it wasn’t obvious from prior posts. It’s cheap and has a good core engine. Expectations are so low vis-a-vis its share price and nothing heroic has to happen for the business to be bigger in five years. While share price based expectations can always get worse, it doesn’t get much worse than UK financials across developed markets.

Last, I mentioned in my past note that paying down our 6.75% mortgage was potentially attractive from a combination of financial and personal money psychology perspectives. I believe that still holds true but for some reason it also doesn’t feel like a slam dunk. I continue to chew on this and expect at some point it will become clear one way or another, like it always does.

Have a great holiday season.

It’s a beautiful morning: clear sky, a full moon glowing, stars everywhere, and much to be thankful for. Not all can say there’s beauty, let alone peace, above their heads.

Markets have been… boring, for me. Not that markets have been boring for all, but for me, they have been. There’s not much to do. A lot of trees have been harvested in the portfolio over 2021 and 2022, and new seedlings planted. It takes time to see how they grow, don’t grow, or die off.

In light of this boredom, perhaps the only thing I have found somewhat interesting is the force with which those who make investments based primarily on historical results have been affected of late. Primarily, in this vein, I think of Compounder-ism. The idea that mega-star management teams that primarily utilize repeat M&A, leverage, and buybacks as the drivers of future value creation. When investing in these sorts of businesses, the typical pitch I see is summarized as: what happened in the past will happen in the future, and if it happens less well, it’s still fine because I’m buying a short-term dip in the stock price.

John Malone is a legend in the business world, immortalized to investors in the book “Cable Cowboy.” It’s a really fun read but tugs at the flaws of human tendency. That is, it creates tribalism around that story of the past. There are scores of Liberty (Malone) investors that have picked at the various securities Malone offered to investors in an effort to recreate the wealth creation of Malone’s past. The focus on the past persisting into the future has unfortunately produced unsatisfactory results from the perspective of returns.

Thinking forward to the future is really, really hard. Furthermore, if buying into a future sentiment shared and reinforced by a tribe, the odds one is already paying for certainty of that future outcome are elevated. But thinking hard about the future is table stakes work. At its core, good investing is very simple: you want to own businesses that will earn materially more money and be owned by substantially more constituents in the future.

VCs are in a difficult position. Coming off the massive run-up post Covid, general sentiment is there is too much money chasing too few deals, with too little talent deploying the said money. But at its core, I think VC investing does encapsulate the simplicity of good investing across the spectrum, well. Invest in a collection of companies with the hope that a few become far larger businesses that many more people are interested in owning. Other forms of investing can easily become complicated and muddied by shorter time horizons, financial engineering-based returns, or a lack of respect for the terminal value of a business.

So what of it? Nothing more than a reminder to myself to think hard about the future but don’t bet on any single outcome. Think hard about the future but form unique opinions that aren’t shared by a tribe. Think hard about the future and consider how many more people may “agree with me, but later.”

Companies that dominate the corporate news cycle often make the simple act of a customer parting ways with their money in exchange for goods or services seem so straightforward. The cream of the crop during a phase of an era proverbially “sells itself.”

However, we all know that the reality is it’s a dogfight for most other companies to simply keep the whole clown car together. Financials-first investors often have no idea what a functioning mess companies are internally. I think they would be horrified to experience that reality firsthand. Securing that near-term revenue dollar, let alone ensuring some measure of long-term value, is a difficult proposition at best.

The quality and security of future revenue vary greatly. Mainstream clothing retailers’ revenue varies dramatically by season and fad, as purchasing is ad-hoc, selection/competition is wide, and preferences change quickly. In contrast, the local utility provider is the only game in town, and you have to purchase to keep the lights on. As such, on average, people tend to pay a higher premium for utilities versus clothing brands, for example.

Lately, I’ve been looking into a certain line of business mostly known to a small niche of folks. Each “sale” generally guarantees revenues for decades, with an average duration of those revenues in the range of 10-15 years. The transactions are lumpy and happen a handful of times annually, though the market is growing quickly and likely peaks around 10 years from now. Only a handful of players can participate in this market, as participation requires substantial internal capabilities, arduous regulatory blessings, deeply investment-grade credit ratings, and a track record that is convincing to the customer.

The companies serving this niche have, to date, generally recouped the money they invest to secure the revenue back in approximately 4-5 years and aim to generate 15-20% returns on that investment for the life of the revenue stream if things go according to plan. All in all, I would consider this a highly attractive revenue stream on face value.

However, the profit stream doesn’t come without risks. One may not receive the above returns if a certain macro factor veers materially off-course. They also won’t make their returns if they didn’t appropriately configure the revenue stream against their costs, a very difficult mistake to correct in this line of business. Lastly, this sort of revenue stream is more episodic, as mentioned, driving more uncertainty about incremental revenue and thus can be viewed as lower quality than one that has better-defined future growth.

All told, the goal of the above is an example of how I attempt to think about business models without bias. How is one to think about things differently than the market if one takes the market narrative as gospel first? The above business line sells for a single digit multiple on supposed profits which may, or may not be the right price. But in a search for value, it certainly is an interesting place to expand one’s portfolio of knowledge.