May 2021 – Brian Roelke, Chief Investment Officer, Kuvare Holdings

Beyond the obvious in manager selection, one area of increasing importance is assessing the diversification of a manager’s access to capital.

Brian, it’s a real pleasure having you join us on Private Capital Call.

1.?Pandemic Environment. You led private capital at Nuveen for five years, then in 2020 became the CIO of a major life and annuity business serving the middle market. What were the challenges of your new job coinciding with COVID 19????

February 2020 was certainly an interesting timing to start any new job in finance, particularly coming in as Kuvare’s first CIO!?In a lot of ways, it was like going right from spring training to game seven of the World Series. I spent my first month getting to know our portfolio, the broader team at Kuvare and our external asset managers. Then on March 11, the world turned upside down. I feel fortunate to have joined an organization with a strong risk culture, positioning us well coming into the year. This provided the liquidity and flexibility to source some attractive investments during that period of dislocation.?

We’ve seen the greatest impact from the pandemic environment in building out the investment team. I’m proud to report that we have grown the team to 20 individuals since I joined; a process made infinitely more complex in the virtual world.?On the positive side, we have demonstrated an ability to work remotely, having invested close to $6 billion together since I joined.?This makes us more comfortable bringing on fully remote talent who may have balked at moving to New York or Chicago, like Jason Powers in Charlotte or Tom Shanklin in Columbus.?On the flip side, it is difficult to build culture at a new organization over a video screen, and I can’t wait until we are able to move into our new office in lower Manhattan, where the majority of our investment team will be based.?

2. Manager Selection. ?How does your perspective of managing investor dollars in the private capital space for almost 20 years prior to Kuvare inform your current responsibilities of picking managers??

In a lot of ways our strategy at Kuvare turns the traditional model on its head, as we rely on best-in-class third-party managers for core fixed income while asking our internal investment teams to add incremental value to our portfolios via niche private asset classes in which we invest directly.?That said, we do have a handful of core relationships with alternative asset managers, and we frequently evaluate new opportunities in this space.

To your point, although I worked on a team with a lot of exposure as a private equity LP, most of my career in private capital has been spent on the GP side of the table. For the first time, I’ve had the chance to see the diversity of approaches out there. Beyond the obvious in manager selection, one area of increasing importance is assessing the diversification of a manager’s access to capital.?For levered vehicles, terms really matter.?A fund’s ability to optimize its leverage profile can have a profound impact on ultimate returns.?Unfunded revolver and DDTL commitments get a lot more attention now than pre-COVID. For example, I can count on one hand the number of investors who got into the weeds on this in the hundreds of investor meetings I had from 2015-19.?

3. Cycles and the Economy. Brian, you’re a keen market observer. Are we embarking on a new, long-term expansion, or will the COVID recovery peter out next year?

My friend Jared Dillian had a great line in one of his recent newsletters – “Instead of a normal business cycle with expansions and contractions, we now have one long perpetual boom, punctuated by the occasional crisis.”

As the post-GFC economic expansion turned into the longest expansion in U.S. history, one of the questions most often heard at investment conferences was “What inning are we in?” Around 2017, I heard someone (odds are good it was you Randy, given the percentage of those panels you moderated!) give a great response—that it was the fourth inning of the second game of a doubleheader.?

If you pull up a graph of the Federal Reserve’s balance sheet from 2003-21, you can clearly see when that second game started—from several years below $1 trillion to a jump just north of $2 trillion in 2009. However, instead of normalizing once the liquidity and credit crunch were behind us, a steady march to $4.5 trillion took place until 2014, where it roughly stayed until last year, minus a brief year or so dip that began in 2018.?The Fed’s balance sheet today??Almost $8 trillion.?For perspective, that’s about a quarter of the total market cap of the S&P 500.

And, given the changes to our banking system put in place since 2008, the traditional model of the Fed exerting influence over the economy is broken. This is because so much of capital formation takes place outside of the direct bank/borrower relationship, financial measures aimed at stimulating economic growth through bank borrowing costs and money supply are no longer directly impacting economic activity—they are going directly to financial?markets instead.?

There is massive asset price inflation everywhere you look. What inning are we in there??When do you realistically see a tightening of monetary policy??Of a return of the Fed’s balance sheet to some number less than $4 trillion??

Although the recent eye-popping CPI print seems to have spooked markets, it is too early to say whether this is the start of a regime change in inflation or simply a reflection of the laws of supply and demand flowing through supply chains just emerging from more than a year of exogenous and artificial distortion.

In considering this question from a longer-term perspective, demographics must enter the discussion.?Here I am sympathetic to the argument that Japan’s experience throughout the last 40 years provides a scenario where we do not experience sustained inflation, despite the massive monetary and fiscal stimulus.?When I read the report from the CDC last week that birth and fertility rates in the US declined to a record low in 2020 , I was reminded that sales of adult diapers have outpaced juvenile diapers in Japan for the last 10 or so years – clearly showing that government stimulus isn’t necessarily always…stimulating.

4. “It’s Different This Time” – One of the features of this (hopefully) post-COVID period seems to be some credit managers throwing caution to the wind. Is the coast really clear? What are the risks in private capital today?

In the world of senior lending to PE sponsor-backed companies, the differences among managers in the traditional middle market can be quite subtle.?It’s a quarter turn of leverage here, 25 bps tighter on spread there or 10% higher adjusted EBITDA.?As the amount of capital raised in the space skyrocketed it became very hard for managers to maintain a tight credit box on every deal. However, those who did comforted themselves with the knowledge that as soon as the economy turned, the chickens would come to roost for those “other guys” whose funds would blow up.

Just when it looked like it would finally happen last March, and the proverbial tide went out so the world would get to see who wasn’t wearing a bathing suit, the Fed stepped in and re-filled the ocean.?Those other guys??They laughed all the way to the bank.

Having had a front-row seat as the largest creditor to a well-known BDC that went through FAS 157-triggered stress in the fourth quarter of 2008, I learned firsthand what sort of damage mark-to-market movement can have on a levered credit platform.?In that case, the asset quality held up, but market volatility in portfolio valuation triggered their debt covenants, eventually leading to a distressed sale of the entire platform.?

When I think about how it is really different this time, that’s what comes to mind – by and large, extinction-level events for credit managers should be pretty remote events, because as an industry mark-to-market risk has been all but eradicated.??

5. Private Capital Features – Our thesis is that private debt was born out of the Great Recession and has come of age during COVID. When asset managers look back in 10 years at their performance, what will they say?

I believe that excess financial market liquidity is driving the most significant potential risk in the industry today—size.?Greater amounts of capital available to managers lead to larger fund and check sizes, which increases the size of companies to which they lend.

This leads to a further blurring of the line between the middle market and the broadly syndicated loan market, and what you wind up with is the worst of both worlds—a broadly syndicated deal structure at slightly better pricing in the hands of a small group of middle-market lenders.?Without typical covenant packages and other middle-market loan protections, a broadly syndicated loan manager would seek to unload stressed credits in advance of true distress.?That is not an option in closely-held middle-market deals.?I believe that over time, we may see a convergence of default and loss rates for upper middle-market lenders and broadly syndicated lenders as a result.

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