How to enhance life insurance portfolio returns

Middle market senior secured loans

Middle market senior secured loans (middle market loans) offer investors the potential opportunity to capture a spread premium relative to large market syndicated bank loans (large market loans) due, in part, to lower levels of liquidity.

The middle market is defined as companies with less than $50 million in EBITDA. Lending involves a concentrated and aligned debtor community that directly structures loans with borrowers. The smaller size and private ownership of these companies makes it difficult for banks to trade the debt which results in lower liquidity, and subsequently buyers tend to hold the assets to maturity.

Middle market loan fundamentals

Although middle market loans are less liquid, they are often higher quality and offer better structural protection relative to large market loans. A simple capital structure with fewer stakeholders enables faster resolution of credit issues, typically resulting in lower defaults and higher recovery rates.

While leverage ratios in the middle market have increased, they remain below those in the large market. Fewer capital providers have resulted in higher yields and more disciplined underwriting. Covenant-lite deal volume has picked up in the middle market, but is still well below the large market.

Middle market loan fundamental comparison to large market loans and high yield bonds

¹ Represents average new issue yields for the twelve months ending September 30, 2014.  Based on middle market and large corporate loan indices per S&P LCD and based on Bank of America/Merrill Lynch Global High-Yield Strategy Index (H0A0). 
² Based on middle market, high-yield, and large market LBO transactions per S&P LCD for Q3 2014 YTD. 
³ Covenant-light percentage represents percentage of volume as of September 2014. 
⁴ Average LTM default rates (by count) per S&P LCD from September 2004 to September 2014. 
⁵ Middle markets loss given default data per GS estimates. Large market losses from S&P based on $-weighted ultimate recoveries for all loans from 1987 to 2013. 
⁶ Loss rate calculated by multiplying LTM default rates (by count) and loss given default rates cited above.

For illustrative purposes only. This information discusses general market activity, industry or sector trends, or other broad based economic, market or political conditions and should not be construed as research or investment advice. There is no guarantee these objectives will be met. Past performance does not guarantee future results, which may vary. 

Supply/demand fundamentals

The spread premium in middle market loans can in part be attributed to supply/demand fundamentals. Middle market companies do not have the same access to financing as large market companies, reflective of a structural change in the middle market.

Prior to the credit crisis, mid-size companies were served by national and regional banks, specialty finance companies, CLOs, and hedge funds. Post-crisis, these funding sources have returned to the large market but not to the middle market.

Illiquidity premium in middle market loans

The illiquidity premium in middle market loans is evident when compared to large market loans of similar credit quality. Over the last five years, middle market B-rated loans have offered on average 130 bps of additional spread over large market B-rated loans. Middle market loans also offer LIBOR floors similar to large market loans.

Middle market lending and insurance portfolios

Insurance companies with appetite for credit assets with lower liquidity have an opportunity to become capital providers where banks are increasingly leaving a void. The cash flows from middle market loans can be used to back intermediate-dated liabilities that do not require a high degree of current liquidity, though insurers would need to manage the duration mismatch due to the floating rate nature of the loans. Loans can be capital efficient for life insurers when rated and held directly on a balance sheet as opposed to in a fund vehicle.

Middle market vs large market Single B loans average discounted spread 

Source: S&P LCD. As of September 30, 2014.

Private equity

Life insurers can capture illiquidity premium by allocating to smaller, less efficient credit markets or they can increase allocations to assets that are inherently less liquid such as private equity. Private equity investments require a long-term commitment from investors, sometimes 10-12 years, which by definition makes the investment illiquid. A long lock-up on capital is crucial for private equity managers to generate returns, and investors' willingness to accept this lock-up reflects an expectation to receive higher returns.

Private equity sources of return

Manager selection is one of the most crucial aspects of private equity investing. Top quartile managers are often successful because of a proven investment philosophy, a unique skill set, or a repeatable investment process, which can result in consistent performance. Private equity manager return dispersion is therefore significantly wider than that of public equity or fixed income managers.

Private equity vs public equity and fixed income return dispersion

Source: Private asset data: Thomson Reuters; Morningstar Principia (public data) as of June 30, 2014.
Note: Private equity fund returns are compared with four-year annualized average returns of public funds, realized over a period starting one year after the private equity fund vintage year. This lag and time-averaging is done in order to take into account the private equity investment period and long time-horizon over which private returns are realized. Private equity data is for funds raised between 1990 and 2013, with returns as of June 30, 2014. The data for public fund returns over the years 1990 through 2013 and are chosen by matching the MorningStar category to the market designations listed in the chart (i.e. they are not necessarily benchmarked to an index which covers the respective market).  

Private equity in an insurance portfolio

Private equity allows insurers to capitalize on a structural advantage to provide liquidity where individuals, banks and other institutional investors are less willing or able.

Life insurers have relatively small equity allocations and generally have the capacity to take more equity risk. High capital charges under U.S. risk based capital guidelines can deter insurers from investments as the post-tax capital charge for private equity investments is 19.5 percent.

However, if we assume a U.S. life insurer holds the industry average equity allocation of 3.3 percent, adding incremental equity exposure can result in a lower risk based capital charge due to a co-variance adjustment in the RBC formula for diversifying investment risk.

Essentially, life insurance companies have an opportunity to earn an illiquidity premium in a market environment where liquidity is increasingly scarce and where the compensation for interest rate and credit risk is limited. Depending upon risk tolerance, there are various asset classes that can offer compensation for taking liquidity risk.

Investment grade emerging market corporates offer an excess spread over comparable developed market corporates. Middle market loans enable life insurers to take advantage of a dislocation in the supply of capital to earn a premium over larger, more liquid loans.

In exchange for long-term patient capital, private equity provides equity risk premium, diversification from fixed income risk, and the potential to earn excess return over liquid assets.