Nick Nemeth: Private Credit Will Blow-up Insurance System | Immense Leverage, Shaky Loans, and Retirement System That Actually Does Have Run Risk (via Surrenders)

Today's episode is brought to you by the Tukurium Corn Fund ticker, C-O-R-N. Let's get into it. Join today by Nick Nemeth, financial investor researcher and author at MissPrice Assets. Nick, welcome to Monetary Matters. Thanks, Jack. It's good to be here. You write about a lot of topics. I think I first stumbled upon your work, the work that you've done on private credit and alternative assets. So private equity, real estate, but primarily private credit. And you have a piece out called, "The Smart Money is the Subprime This Time." And you have some very, very bearish things to say about the private credit industry you say "It doesn't look like 2008. This looks like 1929." So first, what are we talking about here? Just a reminder, viewers, what private equity private credit is. Why are you so concerned? What's the issue here? Yeah, I just wanted to start off and say, "I'm not a perma bearer. You know, I've made money this year. I have read about longs a certain segment of my audience is very interested. In this systemic risk, I've identified that I think is going to be the end of the cycle." And I think the end of the cycle, because it's been a long cycle, basically one, I don't count 2020. I don't count 2022. It's going to be uglier for numerous different reasons. It's kind of like a marriage of built up risks with private credit being the trigger for a massive blowup. That's not going to start in the banking system. Could end up affecting the banking system. But really the mass of the crisis is insurance. Where there's a $10 trillion balance sheet. That's 150% of the Federal Reserve's. Tell me about that. What do you mean? I mean, we're talking about subprime taking down the economy at $1.2 trillion. There's a trillion dollars of private credit, broadly private credit. The concerning part is the direct lending, which is when a private equity company takes debt out kind of like a mortgage in order to buy a business. Now, this can be done well. But they're running leverage at seven times. EBITDA, that's adjusted. So EBITDA, your audience definitely knows this. I go into podcasts and it's less initiated. That's fake earnings. That's what Warren Buffett would call fake earnings. And then they make it doubly fake, because they adjust it on synergies that rarely come true. S&P comes out with data on each vintage. 50% of the time they miss by 25%. Right? And sometimes it's 40 or 50%. So you can adjust those EBITDAs 30%. And then be looking at leverages at nine times that. So the interest coverage that they say too in public markets. So I'm natively the public markets guy. I like seeing prices move. I just think it's a more fun game. I've always thought that from the beginning of my investment career, these private market guys, they like talking stories. And the rubber rarely ever meets the road. Right? All you need to do is be able to exit in seven years. In the beginning of a cycle, that's great. You know, you're exiting in 2018, 2019, maybe 2021, if you're super lucky. And the people are age that have grown up and gone into private equity. They don't know anything different. You have to get to the MD level to see someone that actually felt a cycle and heard the stories. And then they fell apart. And those guys aren't doing the works. And even that, I feel like people are like, well, 2008 can never happen again. Well, the amount of opacity and insurance. Let me tell you, I've been talking to big short guys, guys that put on the trade, research the trade, called the trade. It was pretty simple. I know that sounds arrogant to say. But defaults go up for closures go up and CDOs break. You just had to do the work. Nobody does the work. Nobody does the work in public markets, small caps that I cover, rarely in even the hottest sectors like semiconductors. But when you're talking about insurance, the annual reports, the statutory filings, can get up to 10,000 pages. We're not talking about 500 pages on a 10K. We're talking about 10,000 pages. Yes. So private equity has the way private equity works is they buy companies with debt and then they sell them for a higher value. And that has worked wonderfully for many years. I think the last year where there were exits, so private equity selling their companies at scale was 2021 or maybe 2022. Since then, the Fed has raised rates and they haven't been able to sell the companies, the IPO window, which may be open now. They haven't been able to exit these companies at all. So they haven't been able to pay their investors back. So how have they not paid their investors back by borrowing money? So then you have the rise of private credit. So the dividend recaps is actually a very interesting wrinkle. And that's when you can't exit. So you kind of just push down the creditors. I don't know why creditors ever put up with that, honestly. But then you take debt out in order to pay yourself. You're not selling the company, but you're kind of the risking on the equity side. I actually don't even know if like I don't think creditors really care if a dividend recap is happening. They just buy it. They just, you know, they, I've asked people very smart investors who, and they, they're not really thinking that way. Oh, wait, next, but let's just get back to the broad story. Like, why, why are you concerned right now? I'm concerned because of the massive leverage running and then I look at the credits and I've done low level analysis from BDCs to an insurance. And originally just started off as like, this is going to be not good in a recession. Private equity loves smaller companies. They keep on saying that's where the opportunity lies. Those, the vast majority, I mean 80% of them are cyclical. 30% are super cyclical. The economy this year in 2026 is not that bad. And there are the faults above 2000 late eight levels. So the more work that I've done on this, and it's been about seven, seven months of strict work. I pin this as a problem three years of good clients. I read on sub-stech. I also have institutional clients. In September, October, I'm like, the status center stuff is all ending up here. I got to figure this out. But over the past seven months, that's when my thesis first started that this is a systemic issue. The key to it. And what people constantly say is, well, the banks aren't doing this. There's a shadow banks. Banks are fine. It's there's some lending to broad portfolios. They have some on their balance sheet, but it's not enough to take not the banks. They're right. That does not mean it's not systemic. Because what's happened is that it's ended up on insurance balance sheets. And I started up by saying it's a $10 trillion balance sheet. That's just so much money. That's almost one third of our federal debt. $1 trillion on those balance sheets is private credit. And if those balance sheets go under, people might not know this, but there's no FDIC. They have a guarantee that the other insurance companies will have the money. Do they collect the money? Is it pre-funded? No. It's on their balance sheets almost always tied to a tax credit. So basically, there's no money there. And you're talking about a re-insurance recoverable. If I'm an insurance company, I sell some of my risks to you. Same idea. It's not re-insurance. Re-insurance is a whole another issue. Maybe I've never heard of this. What are you referring to exactly? Like a life insurance company? Is it a mutual thing? Like what do you talk about just so I know? So each state will guarantee 250K. That's the minimum across states. Some states is 300K. Some states is 500K. Of a pension risk transfer. Of a newty. Of a life insurance policy. But it's a million dollar life insurance policies. So there's been recent analogs, 777, PHL, where people that when these companies go into receivership, they don't get their money back. They get 30% five years later. But there are 22 trillion dollars of enforce life insurance. So that's a lot for the states to take on. They want even a very small insurer. Stress is a state balance sheet. Because of Dodd-Frank, when it becomes an orderly wind down if even one big insurer, and these, the private equity, guys, and we'll get into why private equity got into this insurance came. But even one of those, an orderly wind down of those balance sheets, would not just stress private credit. When you're talking about assets and liabilities and you're questioning the assets, it needs a mismatch to happen. When that mismatch happens, then you're winding out an entire balance sheet that might be $350 billion dollars of assets in a fiend's case. It might be on my account. Yes, a theme is owned by Apollo. And kind of started this whole rush into the insurance world. I think it's going to stress everything in credit. And then you have to worry about the more the more good just like, you know, the residential real estate market's bad commercial real estate's disaster. The asset, back to lending, just broadly, the consumer debt, all of this is going to be sold at the market. And I think that it's going to shock this system. In a way that the Fed may not have the tools to respond to, the numbers are so big and it would take a double COVID or at least a COVID level response in a scenario where it's like we don't have a pandemic. We have just a cycle that's gone on too long and there's been an excess risk taken in bad incentives. That is something that's going to be hard to job on. The response to that. Credit markets can be job owned by the Federal Reserve where the Fed prints $2 trillion and $200 trillion of credit becomes unlocked and unfreeze. We're ducking like one to a hundred of facts. That's a good Fed job. I'm worried that people lose trust in the system in a way that the Fed has to, you know, starts with the trillion, goes to two and a half and then ultimately 10. And then you have to worry about the dollar. So Nick, we'll get into the macro and in particular the insurance companies. I've got a lot of questions there. But yes, safe to say, like, you're absolutely right that the insurance companies are very deep into private credit. No doubt about that. We'll get into the details later. Just tell us right now your concerns about the actual assets within private credit. So I think it is fair to say a lot of the riskier loans the banks used to make because of Dodd-Frank Posts Great Financial Crisis regulation. Now the banks are not making them. So suddenly these new private lenders show up and they actually make fantastic returns. Like they make loans at 11% that really should make 7% but no one's there. So they do really well for their investors and maybe defaults are slightly higher than the high yield bond market but recoveries are actually better. So they, I just want to say, like, they have done really well. When did in your view the private credit markets stop performing well and tell us about the defaults that you're seeing and how you define them? So I would push back on the idea that they should yield 7% I don't think that there's anything in credit markets, especially at scale. You could find granular opportunities where you get paid more yield for the risk you're taking on. In the beginning of the private credit, when the banks weren't allowed to do leverage loans and all of a sudden private equity stepping in and new credit vehicles and opportunistic credit stepping in. Sure, there was an ill liquidity premium that was never for 400 basis points, 4% that was maybe 150 to 200 basis points. Because of the incentives, I think that if you see a 9% cost of debt loan in these portfolios and the public markets would be more like 11. I think that you're paying 100 just to be conservative before anyone says, "I'm way off on that 100 basis points. You're paying to have these guys mark their Excel models and you'll be able to tell your pensions everything is smooth returns." If I have a printing shop that makes $40 million a year, that would honestly be pretty good. I do that. But if someone made a loan to me at 9%, you are right that the high-ill bond market is way too big for me. I'm way too small for them. So they're not going to make me a loan. So my alternative is a bank that probably is going to charge me way more or not give me a loan at all, especially if I'm highly indebted. So let's just take that. Yeah, so I hear what you're saying. A lot of big companies that private equity, especially software, if some of these software companies went to a public market, it would be way higher. Let's just say that they were publicly trading. And that also kind of brings another point. The companies that are in private markets are worse companies with less modes than their public market comps. The public market is the best of the best. The software stocks that you've seen down 70%, 50%, those are better than Toma Bravo's portfolio, which included medallia, but I encourage people to go look at the portfolio companies Toma Bravo. I'm not saying that they're all bad, but if you looked at a software stock at $10 billion in compared to a $5-10 billion buyout from Toma Bravo, I'm pretty sure that you would lean towards the public comp. Yeah, they're more like Adobe than they are service now. Service now is, you know, I'm bearish on service now, the tickets and Adobe, I'm bearish on software, generally speaking. But those are way better than what Toma Bravo owns. I mean, they own McAfee. A lot of companies that I'd never seen before, I'd researched and do alternative data to figure out, are they doing well? And the answer is typically no. Here's what I can say with confidence is that if they were public-driven companies, they would also be down 60% to 80%. Like so many other public-focused stocks. I genuinely think that some of these companies, if they were able to be shorted to, right? That's one thing about private equity. You can't short it. They're not used to the heed this year. They kind of got ambushed by that. I think that there's some $2 billion companies in these portfolios that would be, I live in small cap land and micro cap land. I think there would be $250 million companies. Like some of them. The average would be down at least what the average software stock is this year. Okay, so tell me exactly where your concern is located. So software, those deals actually tend to be on the larger side. Or is it the $40 million EBITOP lithography print shop? There's not a lot of that. When I look through these, you can see in the BDCs really well. It's a lot of roll-up strategies. So dental practices, yoga shops. If you go into smaller private funds, it might be gardening or pest control. HVAC is huge even in the public shop. So the software are the biggest deals. Consumer has some big ones. But there's also these roll-up strategies that are built on this idea of EBITOP arbitrage. One of these things, private equity guys, sake, stories they tell a dinner about how they create value. Sure, maybe you can share an account. But the idea that you dilute the quality of business that you do and just roll it up under a bigger company where ultimately inefficiencies can lie. And you can just immediately mark up a role and add on acquisition at seven times EBITOP to 12 times EBITOP. And then say your EBITOP underwriting is X and take out more debt. What you're referring to is you buy one yoga studio that has an HR system, a software system. You buy 20 of them and then you consolidate, you let go of the HR people and consolidate into one software system and achieve synergies. That's the word to use. And then suddenly your earnings are higher and then you can borrow against it. That's where you say it. Yeah, they love the word synergies. I mean, it's really just a capital advantage. I'm not saying that there's no advantage to doing that. If you're buying up all these yoga studios and by the way, you have a $4 billion fund and you can put more money into it and you can take out debt on it at its lower cost of capital in order to renovate your studio and compete with the mom and pops. Yes, but then the question is what if you don't have the capital advantage anymore? Tell me the stress that you're seeing in the credits. You have to do a lot of work to really get granular on it, but you can just Google private credit defaults and it's about 2008 levels. If that happens for an extended period of time, I think six quarters based on my math, then these CLOs, which are collateralized loan obligations in 2000, we have collateralized debt obligations. Now we have loan obligations. You're going to start seeing forced downgrades of those. That's mainly what's on the insurance balance sheet and what I see is a primary trigger. You have to have a capital call and that happens. But defaults are up. Leverage is extreme. Well, I started off with these people are not investors. That was my first piece in private credit. I encourage people to read that one. I think it's kind of lost, lost. But the smart money is a subprime this time. Some of these private funds, they're not even including pick in the leverage because it's not cash and they don't have cash. This is payment in kind, which is like, I borrow a million dollars and I pay back 600,000 of it in cash. I pay back 400,000 of it in payment in kind, which means I just pay them back in more debt. So it's tacked onto the principle. I just want to say, so private credit defaults. Now I think I guess I'm going to take you at your word that they're higher than 2008, but in 2008 they weren't high. That's the point. They weren't high. It was like 6%. But it was a totally different asset class. I mean, so much money is rushed into this. It's the anatomy of a bubble. If you read Soros, the amount of money and it's particularly bad when it happens in credit. A spack bubble. That's not systemic. You know, people lose money. See what's happening in Korea. People are just buying 10x leverage somehow borrowing money, putting it into a broker. When it's credit, it becomes a problem because it gets seized up. What an economy like ours is the lifeblood of the economy, which is dead. How do you define defaults now? Because I've had some people say that defaults in private markets are actually kind of lower than they were a year and a half ago. Yeah, I think you have to have a certain bias to say that things are better than they were in 2024. Defaults and H. It just depends on what basket, if you're including BSL, I mean, maybe what I'm looking at is direct lending companies. And the 6.3% number, I mean, it's SMP or you can do a search on it. It's actually not led by software, which is interesting because software is at 2.3, 2.4%. Again, there's payment kind there. So you can count it as pretend until the end. So one thing that I just want to emphasize to people and everyone will understand this. We're talking about seven times leverage. It's like having credit card debt, sure, maybe it's 11% interest, credit card debt, seven times your pre-tax income. That's the equivalent. And then you adjust it for the fake EBITDA. And your pre-tax income, you really have expenses. So you're adding back something. They add back rent in these EBITDAs, which is pretty insane in some of them. They'll take a car wash. They'll sell the rents or a related party. They'll be able to borrow against the rent. And then they'll pay below market rents on it so that they can borrow more from the bank. And then they'll add back rents. So people in the node do EBITDA, EBITDA plus rent. So seven times can become nine times. And then you add pick and it can become 10 and a half times. So we're talking about you make 100 grand, you have a million dollars in debt. That's how much leverage is running here. And that sounds very high. I'm not saying it's not high. But if your rate is, you're paying 7% on that a million dollars you have in debt, that's 70,000 a year, that is less than you have in income. So that is a, you do have more than enough cash flow to pay off. So that's basically the math, but I think it would be closer to you make $80,000. And if you think about the variability of business performance of these companies on match and recession. And then if you're talking about credit, you need a 90% head rate. Right? Because you're only get, you're up side to cap, you're down side also cap, but it's 100%. It really doesn't work. I see a lot of people ask me like, hey, why don't you focus on private equity? I do focus on private equity. One, if I'm talking about private credit, it's a corollary that this is a commentary on private equity. But at least in private equity, and you see it less these days, but you could have a three, five, 10x income. In private credit, you can only get the money, it can only be money good. That's the best it can be. And if you're looking out and saying, okay, we're going to have some disruption with technology, maybe money got too hot in dental practices, HFAC, all these various sectors. If you have 10% defaults and we're at 6% for an X4 quarters, you have massive problems. Hope you're enjoying today's interview. This episode of Monetary Matters is brought to you by the Tuchrium Corn Fund ticker-C-O-R-N. If you follow the show, you know we spend a lot of time on macro themes like energy transitions, geopolitical risk, and global food security. Corn sits at the intersection of all three. Most people watching the straight of her moves are focused on oil. They should be looking at nitrogen. A third of the world's fertilizer trade passes through that choke point. When that cord or titans, fertilizer prices react, and corn farmers feel it first. Corn is the heaviest nitrogen user in U.S. agriculture, so rising input costs hit their margins quickly. The longer-term story could cut the other way too. If farmers pull back on fertilizer application, yields may come down. If the economics get difficult enough, some may choose to abandon corn and plant something else entirely. 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Commodities and futures generally are volatile, and instruments whose underlying investments include commodities and futures are not suitable for all investors. Pass performance is not guarantee future results. Thanks for listening. Let's get back to today's interview. What kind of recoveries are you forecasting? Do you expect? Way lower than what they're saying. Way lower. I mean, they're selling the hard assets. They're pledging them to get more debt to the amount of credit games that I've been exposed to over this past year. I talked to a premier lawyer and the enemies, and I've been talking to bankers. It's outrageous. And then I'm reading the footnotes and seeing what's pledged to what. And the same lean have different pricing by the same company, meaning there's an agreement among lenders. It might say it's first lean, senior secured, but it's second-first lean, senior secured. The recoveries and software are going to be horrendously low. The data and the majority of these companies, I'm a tech guy. I'm bullish AI. I think there's going to be huge losers in AI, but in aggregate, I think you can justify this plan. Let's just clarify that. The software data and the majority of these porcos, it's just not useful. I've talked to open AI guys, I've talked to anthropic guys. They'll pay a lot one time for really good data. The majority of these software companies do not have really good data. If you are data bricks, which is a private company that's been well-funded by Blackstone and others, they're going to be fine. They're infrastructure. They're going to be the build. It's a great company. But the majority of these are wrappers, a niche process in enterprise spend that can be one-shoted by the frontier models today. They have one to two-year contracts look out when they start rolling off. Today, this is going to come out in a few days, but today IBM comes out and I think that's a story that's going to be told a lot of times. A lot of these were underwritten with 10-15% cager, and that's why they could justify the pick because you could grow into the debt and that's what we're trying to do as a country. If you don't grow though, you are in a major, major problem. Yes. Tell us about the different layers of debt. A lot of times when people say, "Oh, private credit's not that levered." I think they're using some official data that does show that it's actually not that layer, but you track that there are actually five or maybe even six layers of leverage on some of these companies. Jensen Wong talks about the five layer cake of AI. You've got a six layer cake of debt here. Let's start with the operating company and then go down the cake. Start at the top of the cake. They don't talk about the operating company. What they're talking about is the fund level debt. The BDC sells or a collateralized fund obligation. Underline credits, as we talked about, are seven times leverage to be generous. That means that to a business outcome, if you miss EBITDA by 25%, leverage to the outcome is significant. Then you have the underlying portfolio of companies. BDC might sell senior debt, pledge assets, funding agreements. That can be about 30%, 40%. I think that's what typically people think of when they're talking about how much leverage is in this asset class. Then you have the underlying debt of the money that's going into the funds. If you think about the people that will go into a fund, it's going to be allocators, wealthy individuals, and the general partners, the general partners being the people that make the investment decisions at the firm. The allocators might be sovereign wealth, pension funds, or insurance companies. The pension funds are not that lever. It also endowments. The pension funds are not that levered and downments are more so. There might be funding subscription lines where they don't have the money right now, but they'll have them in three months. That's not so worrying. The sovereign wealth side, as the Arabs have contributed, I believe, a trillion dollars to private markets. They currently have a trillion dollars allocated to private markets. They will do a repurchase agreement in order to send a hundred million dollars of U.S. treasuries, a 10-year, to maybe Norge's bank or some European bank or some American bank, or they can just ask out percent for a swap line. Then they will get back minus Erika a billion dollars. There could be 10x leverage there. Potentially up to, I've heard, 20x leverage. They will contribute that billion dollars that they originally had a hundred million to different private equity funds, broadly speaking, maybe 250 million a pop. That's from the inside. then adjacent to that, the general part. can borrow from their funds or this burgeoning GP financing industry where it's maybe 7% cost of capital and they get your stake if you can't pay it's basically a margin loan into it. 5X leverage on that and they can justify this because none of them believe that you're ever going to get negative returns over the course of a Pee fund or a private credit fund. So you have this from the bottom you have GPs and LPs leveraging up into private credit and private equity funds. Then on the equity side the private credit is leveraged to the equity and then under each of those portfolios you might have 30% LTP meaning loans against the entire portfolio that is first lead. Meaning the GPs and LPs don't get any money. The banks or the insurance companies that lend to the broader funds get the money first get the returns first and that's what people typically say they're not that levered. Once you stack it all up and there's some smaller ones too I believe that there's only in a buyout industry total private equity debt which includes private capitals about 10 trillion. What's leveraged buyouts is a little bit over 4 trillion. I believe that there's only a trillion dollars of cash that's gone into that industry like legitimate cash. Not I. You're saying that it's mostly borrowed money. It's mostly borrowed money. Yeah. So if I have margin on my stock portfolio and I make a purchase for a home I consider that as no equity right. I think a trillion dollars directly into it but then there's also ways that there can be more leverage in different you know it might not be directly in that chain but it might be adjacent like the stock portfolio margin versus buying a home as well. Just how big are these loans because I know that a lot of these loans have actually been extremely well performing like Silicon Valley Bank did subscription lines and even though Silicon Valley Bank failed I think that their subscription line business had one or two defaults in the entire history of the business because like yeah if you lend Harvard money for 30 days so you're lending Harvard money so they can invest in the fund and then they pay back in 30 days like Harvard's good for it you know the Saudis as you say the Arabs they're good for it. Yeah you're just smoothing it out. It's not that concerning the subscription line stuff yeah but you're also seeing Harvard good at debt yes they're going to debt capital markets they're so is Yale. Yale is 50% in privates right now 50% of their money is in a liquid assets that they better get back based on the amount of money that they spend so they're actually selling bonds in order to fix the liquidity problem and again counting on the exits actually happening that's when it's actually legit. Yes I almost like because of the Trump administration's policies towards like Ivy League universities and such that's also a pressure there so it's it's you know many many many forces of why they're issuing bonds but the facts that you said are are correct I'm not going to dispute them okay so why do you say that this is 1929 and not 2008? 2008 heard the little guy 1929 there's a lot of people they got extremely wealthy off the stock market and they heard the people they got wiped out so my point there is if you think about the people taking excess risk there's some great stories in the big short or otherwise and you know it's an adult entertainment dancer that has four homes and she's like oh you know I've got some money and this is a great investment and that those were the foreclosures this time I see the white collar workers being primary effect I see the cause of this being the private equity guys that went into insurance and made it a profit center they did the Warren Bruck Buffett approach but started taking F 35 level risk okay so now as as I promise we'll go go to the insurance sector so you were absolutely right that the private credit industry and broadly the alternative asset management industry has they're always looking for investors of course you know as as most investors are and when you're managing other people's money and they've turned to the insurance companies to manage their money and in some instances they literally bought the insurance company so Apollo created an insurance company about an insurance company Athene KKR did the same with a company and money all the other big alternative asset managers that are publicly traded have a giant arm of managing insurance capital and I also believe that a lot of this insurance capital is in the health and life space so so annuities life insurance and the like which on the underwriting side is a little bit of a commodity so like in the you know if I'm if I'm writing flood insurance and you're writing flood insurance and we're competitors you may be way better at pricing than I am because you have some special insight on like the hurricane patterns or California or Florida whatever some sort of niche in the market that's extremely rare in like life and health insurance it very it is like a commodity like the actuaries have figured out if you have you know if you have a insurance pool of 500,000 people like they know how much it costs just because it's the law of large numbers so then how do you get an edge as a life and health insurance you it's really you're not insurance business you're in your investment business that's the sky says so the insurance business yeah that's a that's a sophisticated point that you made about the commoditization of this asset class there's not a lot of variability to it if your home is inland in Florida maybe you have better data on that yes so to again the balance sheets are so massive this is where it's been a lot of my recent time on it because I think that there's an amazing trading opportunity shorting these balance sheets honestly they have seen these assets and the one thing you didn't mention the primary reason they like this capital is because to them it's permanent right those call it permanent capital it's not a permanent nothing in life is permanent but they call it permanent and they think that the duration is long and the asset and liabilities are perfectly matched and yeah you're talking about alternative asset management firms they have an issue in private credit they in 2015 they go to all the big you know rich investors they fly to Saudi Arabia they fly to Buoy they fly to go to all the endowments they raise a fund seven years later they pay back the fund they've got to raise all that money again it's it's operationally it must be very tiresome and it's not ideal as a business to do that so perps permanent capital are like literally we are going to just manages money forever and if we literally own the insurance company it is it is permanent capital kind of unless the unless unless they go out of business so they're not crazy calling a permanent capital but also they they do call they they call public business development companies where they you know manage stuff for public investors they call that permanent capital and they as you know I'm sure you know this they count the debt in that funds as permanent capital when they're reporting that to investors which doesn't seem to me to be very straightforward or direct on the insurance side one thing you know just to fill fill in something there's a thing called surrenders you can ask for your money back they just don't think that'll ever happen in excess of they they don't think there's a real tail event scenario there I hope there's one actuary listening and I've spoken to a lot a lot of actuaries they'll model out if interest rates go up typically what's happens what's a two three standard deviation move actuaries if you find a really good one they also understand the investment side the actuary math these it's pretty they have to take 11 tests 11 math tests they're good at math but being good at math and understanding the asset side of the equation is a really hard picture to put together but they know what would potentially set off surrenders except if you don't understand the risk you're taking on the asset side you can't imagine a reputational risk that would spike six standard standard deviations and you would think is a one in a thousand year move but I believe is inevitable there are actuaries that can do it and there's maybe 50 in the country being conservative maybe I'm speaking to one yeah no no no and I mean the people who structured mortgage-backed securities and subprime CDOs they were good at math too yeah yeah the LTCM yeah I actually think I'm gonna have someone a co-founder of LTCM on podcast pretty soon so he's he's very good at math we'll see so but Nick the argument about when you hold risky assets that cannot be sold in a fire sale other than at severely reduced prices on a bank balance sheet where people can pull their money from make it anytime that is extremely risky the argument that the the alternative asset and management industry makes and that the regulators actually kind of like, is hey, this is long-term capital, or as I say, perpetual capital, you can't pull your money. You can't pull your money as a depositor or a poll. We don't have any depositors. We just have people who are clients, and they can't pull their money. And then we also have people who are clients of our insurance company, and they can't pull their money. But you're talking about surrenders. Just how much is the surrender cost? 'Cause this is something I had not considered. Really low. Really low. And Athene, I know well, I've done a lot of work on Athene. Seven percent in year one, five percent in year two, and then it goes down for five years after that. This is the gap of how much you can surrender? No, it's the penalty of everything you've given them, you can get back. You leave seven percent. So seven percent is not, for some reason, people think that's the gonna stop people. People will sell a stock when it's down 50%. When they're panicking, if the actual panic is my insurance company is at risk, they'll pay whatever. And two thirds of, or two thirds are one third. I don't wanna be wrong. Of a theme's completely outside the window. It's probably one third. Go with a safer number. Is completely outside the window of any penalty whatsoever. But if you're in year three, it's three percent. And what people don't understand is that, especially the worst products, if it's some sort of, specialized products or more risk being taken on the balance sheet, they'll pay out a salesperson, 10%, and they'll be the entire first year of premiums that are paid. So if you go through one year, a theme pays out salesperson, Annika or American equity in life, will pay out a salesperson. Then in year two, they say, I want my money back. Let's say it's a year, it might be a three percent penalty. You pay about 10%. You gotta go find the assets on your balance sheet. A theme has 8% level one assets. And it's all treasuries and it's all cash. Then they have a good amount of level two assets, a lot of mortgages, some corporates, and they have about 50% level three assets. So recognizing that the majority of that, you're trusting a theme in order to price appropriately. If you have an uptick in surrender, it doesn't have to be that big. Because what we're not understanding is that these insurers balance sheets are levered up. In many cases, more than Lehman Brothers was in 2008. I mean, we're talking 90 times, 100 times in some case. Some have negative equity and a commissioner said, well, you don't have to mark to market. Here's an exemption or you don't have to do the, here's a fair value exemption. So now you don't have infinite leverage. You have only 70 times leverage. There are better ones, right? I don't want to sound like all insurance guys I'm going after the savvy ones know exactly what I'm talking about, compare New York life to a theme, compare New York life to a carlile. What carlile has been doing is the through fortitude is where they have negative book value and they got an exemption. So that is interesting. I was going to say that I imagine some of the insurance companies that have very low equity. Some of that would be because of duration. So interest rates going up, not credit. I mean, like even at the peak of interest rates in like early 2023, if you looked at Bank of America, because equity on a market value basis, it wasn't looking so hot. And I pointed that out and actually people accused me of trying to start a run on Bank of America, which of course I was not. So, but you're saying that this is from credit. - No, Bank of America. Bank of America bought $600 billion of 20 year bonds in 2021. They kind of were forced into it by the government. So the government was like, here's a $2 billion. - It was agency mortgage-backed securities. So very essentially no credit risk, but lots of convexity and duration risk. So the asset liability mismatch is important. You could be negative as long as it doesn't have to be realized. You can just lose money to inflation or whatever it is, right? The amount of credit write downs that are proactive on these insurance companies is functionally zero. What we see per year, it's, you know, interest rates are up, it's eating these underlying credits. If you have a mortgage-backed security, might be agency or non-agency, however many years, it's just duration and then they have treasuries. It's duration. Typically they on the market on fair value, but in the case of fortitude, they got an exemption because that was too ugly. - I think it would have to be a very extreme scenario of everyone pulling their money at the same time. I'm not saying it's impossible. It does seem unlikely. - It does seem unlikely until you figure out that it only takes single digits, low single digits for over a hundred of these 680 insurers to be inside the, they talk about these RBC ratios and capital reserves. - With this very capital. - Yeah, it's kind of like tier one capital. - People can live in financial markets for their entire lives and not know what these means, but it's basically, they say that they have four times as much as they need, right? That's what they tap. The problem is the number that they need is incredibly low. That's where we get to the ratings and the ratings being important, just like in 2008. In 2008, those all AAA rated paper. Was it the most riskless credit in the world? No, it was not, but the ratings agencies got it wrong and I think the ratings agencies are getting it wrong all over again. And they are kind of constrained. I've talked to Fitch and Moody's analysts that've rated these insurance companies. I have to say, I just default to think that anyone that puts up with something that I think is ridiculous. I think that they're not intelligent. I think they must be not intelligent. There's no way you can be an intelligent and sit there and allow this to happen. Are you talking about Fitch Moody's S&P rating the insurance companies or the assets that the insurance company's own private credit? Well, they don't do that. Egan Jones and Crowell do that for them. So just going back, I was talking to the Fitch guys. They're not dumb, they're not dumb. They are paid to be dumb. It is the function and the model of those businesses. They are not paid to ask questions and they have to rely on the underlying credit. So for a long time, they would just say, these are 100 B's, okay. And let's make that a slice it. How much equity cushion is there? How many mesonine classes? How big are the mesonine classes? What's the senior, okay, AA? I mean, AAA, AA, triple B, double B. But now you're talking about structured credit. I mean, what are you talking about? CLO's here or just? The CLO's are what's largely on the insurer. Okay. Triple B rated mesonine paper is, there's a Barclays report on this. Super outsized exposure to that and talking to actuaries. That's like the min max of how much capital you have to reserve and how much yield you can get. So that's why triple B, CLO's are what insurance is rushing towards. Again, just trying to get the most profit that they possibly can. But then the underlying insurance groups and they're all rated equally. There's like five different entities in a theme. There's at least, there's so many in potential, but there's one bad one, but it will get all of the, they will get the rating of the parent company. So they're all rated the same. And when they rate the Athene debt or the potential, that life, Lincoln, FNG, Jackson debt, they're looking at CLO's that are triple B. So it's a rating on insurance debt that allows them to get access to capital. And it is based off of rating on CLO's and those ratings on CLO's are based on ratings by these actually stupid people. Okay. CLO rating, we all know that is coming from Moody's and S&P and Fitch, the big guys. Morningstar has actually got a little credit rating department as well. And but the assets in those CLO's that make up the underlying loan, those are rated. It's too expensive to have S&P or Fitch rate your underlying credit and they don't want to. There's a reason. Okay, but doesn't like Moody's and S&P say that they're rolling out private markets coverage? Like they say that on the calls. I don't know. Yeah. I'm sure they're trying to get business where they can get business, but they're too expensive and I will criticize them. The difference between CROL and Egan Jones and Moody's is massive. Right? So when you're relying on those markets, if you're a private equity company, you just want the lowest cost of capital. What does that mean? You want the highest rating? Where are you going to get the highest rating? You're going to go to Egan Jones. Does Moody's want to rate your credit for 150 grand? Yes. Right? Are they rolling out that business line item? Yes, especially when people are talking about the Egan Jones credits. But all of these ratings are not based on the actual credits and the business fundamentals being looked at by Fitcher Moody's. It's kind of just sausage inside of sausage inside of sausage and you're just rating letter grades. Yeah, I understand that the underlying loans are being rated by like D tier credit rating firms like Egan Jones. After. Yeah. After. You can't be worse than Egan Jones. Yeah, I mean, there are like Bloomberg articles just about how many ratings, I mean, they are ratings factory of just. So before AI, they were doing. Like, if this is the big short moment, you know, which sounds like you are leading towards the answer is yes. On that question, like, and there's a movie about it, which you probably won't, let's be honest. But that scene of the woman, the woman who's blind, who works, you know, he's just got lasex surgery and she's wearing the glasses. She would be. She would work at Egan Jones. Yeah. And then the guy that's talking to Mark Baum and Vegas, he would be. Actually, there's multiple different characters he can be. And, you know, listen. I think that what's happening now is so ironic. We've all seen the big short. We grew up with that through the Grilleble financial crisis and then the media that resulted from it. That I think that people. It can't like, it can't be so similar. That's what people believe. It can't be so similar. Anyone says it's just like a wait. Must be, you know, short-cutting the work. If you actually do the work and you think about the incentives and you've had conversations and I just. I love history, whether it's living history or financial history. I was talking to the head of a mortgage division out of major bank and he was saying that he wrote a diary for the first time in 2008. He'd never done that before and he never thought it would happen and he never thought it would be as bad as it was. And I just think about the incentives and it is so similar to me. And the reason being is that Dodd-Frank didn't fix anything. It didn't do anything. It pushed the risk and then even worse, it gave all of these institutions the understanding that one of us will go down and then everyone else will be declared systemically important. It will be an orderly wind down. Assets will crash for a second because nobody wants to be the buyer first resort and then the Fed will come and backstop it. But like I said, that works if you're talking $250 billion. Tarp was $750 billion. You know, the repo facility for after SVB was $250 billion. The Tarp was only drawn from $440 billion. The numbers we're talking about, I think, are starting. The Federal Reserve is a big ape and I think we're talking about an elephant. It does sound quite different from 2008 in quality. I understand in scale, you say it could be as big maybe even bigger, but I mean it's yeah, the banking system, it's not in the banking system, it's in the insurance industry and it's not in mortgages, it's in private credit mainly to companies. That is a substantial difference. But tell me, so do you really think that there could be a run on all of these insurance companies at the same time in the same way that you had, you know, during the financial crisis, if you know the bank is going down, it's you just literally pull your money. And then if you are in the repo market, you're a highly sophisticated player. You know how to put your money overnight, you're following these things. I bet a lot of people who have life insurance with these companies that have a different name than the parent company that's having issues in the credit market, they probably, I don't know, I don't know if they're going to imagine. Anyway, what do you say? It's hard to imagine. Yeah, yeah, I'm not saying it's impossible, to be clear, I'm not. It's hard to imagine for everyone, but they would have said that about SVB and then all of a sudden on social media, everyone's going viral. Like, you remember the bear case on SVB, people are like, it's never going to be recognized, right? Same thing with a bank of America. Then all of a sudden, there's just a tip and then there's a bad call. And once the bad call happens where they're saying, everyone don't panic, don't worry, we're just raising money, it's not for any reason. And all of a sudden, it's like the game's up. When that happens, what else happened? Did SVB, would first Republic have gone down if it wasn't for SVB? No, no. And then you have contagion, right? So I think it's really hard for people to imagine the virality of these things. And I think that there's a very interesting story that would do very well on social media. Everyone I talk to, I would say 90% of them sit in your camp of its hard to imagine. And I think it's an inevitability. That's like the super tail scenario where you're going to 15%, 20%, redemptions. But if it's, we're talking single digits, or what needed to take the first one down, that's, you know, it could just happen because rates are higher and credits go down and things can just get compressed. So you say, as surrender rates would only have to go to single digits, like 9% and then that is more. So some of them have 10% surrenders per year. But what surrenders are today? A little bit of people just need money, a little bit of people, you know, interest rates go up and by the way, they realize it's a terrible product to begin with just buy a five year treasury or a 10 year treasury. But the modeling of it is very tight in terms of what the standard deviation is. But the outlier, especially if you're private equity backed in, sure, with 25% allocation to private credit running at 60 times leverage, you might have capitalized your sales assets. So it looks like your capital surplus isn't more. In a theme's case, they have good will on their gap equity. A lot of related party paper that you can assume is less is more likely to be mismarked. We're telling you we're talking about it going from 8 to 11, you know, it could go from 10 to 14. We're not talking about much. But didn't you say that half of the assets are level one like deposits and cash treasuries? No. Oh, okay. So what is the percentage of level one? On a theme, it is under 10%. Oh, okay. I'm totally misheard of you. Okay. Sorry. And then so what is then they do 40% is level two. Okay. Right. So which are corporate bonds and agency mortgage tax securities which like realistically can be sold even during a financial crisis, you know. Yeah. I mean during financial crisis, you could sell anything at $37. Right. Yes. But I'm saying like a Microsoft bond is, you know, they're going to have Microsoft bond. It's too low. You know, right. Okay. I mean, very little, they'll have a lot of mortgages, a huge mortgage book that they're always trying to min max yield and returns. And remember, they're paying, they have to pay for the entire enterprise of insurance. Their cost of capital is, in a lot of cases, 78%. They're not going into a Microsoft bond unless it's the, it's the best way to get some quality on your balance. Like that is not going to pay for their cost of capital. They're losing money on that. They'll have treasuries. They'll have cash. They'll have high grade and the corporates. But that is legitimately just because they have to. Then the stuff that is yielding more than their cost of capital, if you're single A, is all private credit. If you're double A, it might be high yield publicly traded bonds. Again, if you look at HYG, TransDymes is in there. It just runs levered high yield in public markets is not the same as what these loans are. And it doesn't yield the same. You know, that it's pretty obvious. They're going further and further down the risk spectrum because one executives and public companies need to pay dividends and they want to get compensated and hedge funds like it and allocators like seeing cash earnings. But on the private equity side, these are profit centers. And also, by the way, they collect fees on the assets. So they will take and they will try to maximize the spread on their cost. I think it is fair to say that in the private credit world, Apollo has actually one of the best reputations specifically for finding the best loans and for underwriting, which is basically finding the highest rewarding lowest risk relative to risk loans. Do you think that that just that that reputation is justified? I think that they are good underwriters. I think that they have amazing lawyers. And I think that's really their advantage. They are sharks. And if you're in a deal with Apollo, look out, they will cut you out. You know, numerous examples ask anyone. I just think that they're running risk at an F-35 level. Yes, could they be an elite fighter set of fighter pilots? Yes. But you're all also seeing examples of failures like the insurance and Germany, for example, commercial real estate and Germany, they make mistakes. Now do they have enough of a capital barrier on 300 and 300 billion dollars of assets where I have calculated the real capital as more like four to six billion than 20 or 30 that they're saying, statutory at 4.1 or 4.2? That's like a razor then margin of error. Having said that, if we assume that Apollo is actually pretty good at moving out of hot sectors unlike Blackstone, right? Blackstone seems to love the hottest memo trade of the year in private credit. Apollo makes marginal moves that you can point at and say, okay, these guys are, you know, they're better than their peers. What about the, if we, so if we say they are the top of the league tables, right? We have 680 companies. What about number 50? Number 50 might have a billion dollars of assets. What about number 200? 200 might have 50 billion dollars of assets. And 50 billion dollars going onto a state's balance sheet will stress it. It will stress it and they'll bring down a 75 billion dollar one. So if you're thinking that if we set the, the, the bar as okay, but Apollo is smart, they can do it. Do you think that Apollo is better than every other private equity company? Do you think a theme has better asset investment and actuary math than every other insurance company by how much and understand that that risk level because of people have to compete. They need market shares. Communities as you said is taken down the league tables in mutual funds where there's not necessarily a profit set of its way better. But I have to tell you, mass mutual, I've been working with a guy named Rod Dubitsky, worked at Fitch, called the big short. People should look him up as well. I think he's coming up, he came out with a report on mass mutual. They have 25% private credit. So there's massive dispersion. And again, if you have three, if you have 150 billion dollars of assets go under, that's a problem. That's a major problem. SVB was what, 250 billion dollars of assets? It was sound about right? Yeah, yeah. What was the percentage of treasuries and mortgage-backed securities? A very high percentage. Right. So that's generally, especially the Fed comes in and says, hey, we're going to make sure that there's a big facility and it's going to be fine. That's easy to wind down, especially if you give it a runway, we're going to wind it down over 18 months. And you have so many level three assets, the marks could be way off. And the amount of work that you have to do to figure out if this dental roll-up is actually doing well. People are just going to be like, okay, I'll give you 25 cents for it. Yeah, the state, the insurance company, the state balance sheet of Wyoming is not equipped to do no offense to them. Analysis on whether the loan to the roll-up for dental offices is good. I'm not equipped either to be clear. I'm not being a snob. That's what the Dodd-Frank did. It's really funny, too. They'll call in actuaries to help wind these things down. And I've talked to a couple of them. And when they go in there, it's a mess. And they're calling the investment side of them. And still, you're giving the regulators, how do you orderly wind this thing down? What do we do? Now we're trusting the government to make wise decisions for the taxpayer because the taxpayer is paying for it. Nick, tell us specifically what form the private credit it is in. Like you said, 25% of private credit on mass mutual. Because earlier you said that it's mostly in the CLOs. And there's two types of CLOs, CLOs that contain more. That contain like broadly syndicated loans, as you said earlier, BSL. And then the so-called middle market CLOs, which contain middle market loans, aka, it's a term for private credit. But like, are you counting like if an insurance company like MetLife has a bunch of CLOs that are actually broadly syndicated loans? And like one of the loans is to trans dime, which you say you don't have a problem with. Are you counting that? Because I think that even though the share of CLOs has gotten more middle markets and more private credit, then the share has gone up. But it's still not a giant percentage, right? Of the middle market CLOs? Of the CLO market. I think it's still mostly broadly syndicated loans, not middle market. There's a lot of broadly syndicated loans and there is a dispersion there, but a lot of the broadly syndicated loans are software, right? The bigger stuff that trades. So your concern to be clear is not only referred to like direct lending private credit middle market, it is also broadly syndicated loans. Yeah, I mean, I don't think that all that much changes. Sure, you know, there's a Q-set. Sure, you can get a quote. But when we're talking about liquidity, and again, I traffic in small cap, stop. Top of book liquidity is not liquidity, right? Just because you can trade a haircut at relatively close to part does not mean that it's, that's the price, like that's the liquidation price. The orderly wind down price. And I want to go back to what you said, how, you know, the difference between 2008 and today, 2008 was in the collateral system, right? That was a fundamental crisis in the collateral system. Today it's not. Today it's not. It's not going to be a collateral crisis where because that's tight, people have to sell everything. I think it's going to be people are going to sell everything because it's a credit crisis. And you're going to be looking in order to fund because you can't sell the liquid stuff, you're going to sell high yield debt. You're going to sell what you can as Boa's Weinstein says. Mm-hmm. Nick, who, I'm just going to a lightning round of the publicly traded asset managers. We talked about Apollo. What do you make of Aries? I think Aries has the biggest gap of brand name Coca-Cola or two reality. And I've done a lot of work on ARCC as a BDC. And this is what people can see and they can verify. Go. And maybe I should come out with something on this. Go compare that to FSK. Everyone thinks FSK is junk. Why at least seen as a low quality publicly traded business development company that has problems to put them out late. All the professionals hate FSK. Yeah, yeah. Right. Compare that to ARCC. So, I'd love it. Love it. ARCC by, yeah. Exactly. You know, one has a 50% discount. More or less one is less than 5% discount consistently. Both have 60% software. ARCC has more subordinated debt. Now, in their business is having a brand and having professionals believe that your God's gift earth is that pro to the business? Sure. But that is the one that I would knock down the most in terms of reality. Blackstone is next in terms of I feel like the entire business is marketing, entire business. The way that they have Bloomberg or Fitch reporters and do Instagram reels. John Gray is not a math guy. He's an operator through and through. When I look at Mark Rowan and I listen to Mark Rowan speak and Zito speak, there are people that, okay, they're used to making investment decisions. I kind of, I don't disagree with them, but I see somebody who's an investment person. When I look at John Gray, I see a narrator. You're talking about the CEO of Blackstone. I will say, your bullish an AI, so it's not like your bullish on semis and data centers. Blackstone's got a lot of data center exposure. So if you're right about that, they could do well there. Yeah, okay. What about Blue Al? Blue Al is the one that I would bump up the most. They're underrated. Yeah. Blue Al's, their public relations is the worst thing I've ever seen. The worst thing I've ever seen. I've caught them giving $20 million to a nuclear company that doesn't do anything. Absolute bogeous. It's awful. Having said that, going through OCIC, OBDC, they're-- Wait, Blue Al gave $20 million to a short report? No, I wrote a short report and I'm like, Blue Al, what are you doing here? They gave it $20 million. There's actual hot air behind that company. So they will make mistakes. You can find mistakes, but overwhelmingly analyzing their portfolios. They will do the related party to Guvare. They are not what the market thinks has that much worse. Now, I'm not saying that the stock is a stock, no financial advice. Reputation really matters. Your PR, your marketing really matters for these businesses. Anytime there's just a stink on you, just because you're as good underwriters as Blackstone doesn't mean that because there's a discount in your multiple or anything like that, it's a buy. But-- because reputation matters so much and if you have a good reputation, you continue to get inflows. If you have a bad reputation, you continue to get outflows. Outflows can cause bad performance, which causes-- more outflows, it's a vicious cycle. It's incredibly reflexive. You're seeing areas in Apollo be able to raise money. Blackstone's not. So, you know, I'll bump the most overrated as areas the most underrated as Blue Al. That is a very contrarian take. I like, I'm here for it. Teppnik tell me about the outflow inflow situations, like so far for a lot of this interview, you've described dry, you know, kindling, which by your eyes to your eyes seems extremely dry and extremely ripe to go into a giant bonfire. But like, what is the match? I mean, the match has to be outflows. And before you have outflows, you have to have inflows stop. I think for some, like, Blue Alphons, the inflows have been not very good. And I know there's also a lag. Just tell us your picture, your view of the inflow outflow dynamic in the private credit market. So, I think that this asset class and everything, the spreads, the multiples and private equity is all built on consistent inflows, consistent massive inflows. It's like when the monetary supply is going up 10% every year, if it goes down to 5%, you have a problem. Because everything is priced off of that 10%, and the rate of change is painful. So I think that is it. I think you have that. And then there's a problem on refice, especially when you get to the disruption in the software wall. So I do think that there's opportunity for money to be coming out of the asset class. The money that is returned is the first money that is returned in a long time. Or not much this year, pensions aren't going to reallocate the private credit. On the open funds, if you come out of an open fund and go and buy a Aries at 95 cents, because you see an immediate OIC, or when they do these loans, they get an immediate markup. This could be your immediate markup. You could go out of Blackstone at B cred into Aries at even a 5% discount, or Fsk at 50% discount. If you believe in the asset. You're talking about taking money out of private's market, 100, put it into public assets that have very similar assets at a discount. That's what you're talking about. Very similar. They're closed, but you can buy the rights to the dividends, if there's dividends. That's money coming out of the asset class. Even just that swap. As long as the game theory says, and participants in economics will go towards the value that's so obvious, there's enough information out there. They should just go to the closed funds at a discount. It's 80% similar. Substantially similar to using IRS term. They don't do that because they don't want to see the prices move. But over time, I think all it takes is less money, more scrutiny going into the asset class. Then all of a sudden defaults pick up, and then redemptions pick up again. It just says this every bubble. Everything is reflexive on the upside, and it's also a deductive on the downside. Absolutely. It is extremely prosickly. We will leave it there. What are the themes stocks you're looking at? The theme is stuff that's way off. I don't want to talk about Google if it's marginally consensus. I try to find stories that are going to be multibaggers or down over 50% on the short side. Typically I traffic in smaller companies. Mid-caps for technology because small caps and technology are typically not that great, especially when AI has been pumping a lot of stuff recently. It's long, short, and macro coverage. Basically whatever gets me extremely excited in order to do enough research on. They feel like I have something to say. We'll leave it there. Thanks, Nick. Thanks, Jack. Hope you enjoyed today's episode. Those interested in learning more about the Tukyum Corn Fund ticker-C-O-R-N can find more information in the link in the description. Until next time.