"Liquidity is a public good. The more liquid markets are, the more efficient the economy." - Bengt Holmström
On March 22, 2021, the Financial Times headline read “the New Berkshire Hathaway?” The firm in question was Apollo Global Management APO 0.00%↑ and its pending merger with life insurance company Athene. Perhaps it was the interrogative form that spared Apollo from the curse of comparison with the Oracle of Omaha; since publication, shares of the alternative asset manager have risen 150%, trouncing rival Blackstone (93%) and the S&P 500 (39%) along the way.
The tone of the article danced on skepticism. By 2022, alternative asset management had firmly established itself as a Very Good Business™️. What was once a cottage industry of gunslingers had grown to control some $5 trillion of assets. These firms were capital-light, collecting rich fees using other people’s money to buy companies, real estate, and infrastructure. This model used both explicit leverage and the implicit leverage of LP capital, which created asymmetric payoffs for the managers when things went right. Because their clients were mostly institutions, they benefitted from a light regulatory touch.
Insurance, by comparison, is capital intensive, has a low margin, and is highly regulated. For years, alternative managers have been happy to help insurance firms manage a portion of their assets, but being one themselves held little appeal. The FT noted that bringing an insurance company fully onto the balance sheet would surely weigh on Apollo’s valuation multiple. Under the large tent of insurance, there is a spectrum of liabilities ranging from simple to actuarially complex. Complex liabilities include products like long-term care insurance, property & casualty lines. Simple liabilities are more akin to investment products like annuities and pension liabilities.
Annuities guarantee a given income level at retirement. Other annuity types track hedgable benchmarks, but in sum, these products provide insurance companies with long-duration, more or less fixed-rate liabilities. In turn, insurance companies invest 80-95% of this capital in investment-grade debt, seeking to earn a small spread between their investment returns and funding costs. The remaining 5-15% can take more risk, investing in equity and other alternatives. For years, alternative managers focused on managing this small sliver of insurance capital. In bringing Athene fully onto the balance sheet, Apollo would earn meager spreads on the investment-grade book but have captive control over all of the risk (equity) capital portion.
Now, virtually every alternative asset manager is trying to recreate the Apollo flywheel. But this model did not rise out of the ether of financial engineering, a culmination of factors converged in ways that will potentially alter both financial markets and society. The aftermath of the GFC saw bank lending severely restricted. Meanwhile, rates began a downward march to the lower bound.
This created growth in the private credit asset class for alternative managers. For insurers, it severely impaired the economics of their annuity business. With each passing year, rates fell below the rates at which policies had been originated. Before long, insurers began offloading these assets at sizable discounts to appease public shareholders, who were growing increasingly worried about the imbalance.
Few people foresaw what Apollo CEO Marc Rowan was building. Rowan’s innovation was using the equity portion of the insurance balance sheet to seed new debt origination platforms with equity. Those platforms could themselves benefit from the traditional private equity LP structure while also originating assets that could feed both the investment-grade and equity portion of the insurance balance sheet. Commentator Red Deer has an excellent deep dive into the details of this structure but in brief,
“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…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 the introduction of incremental OPM at every stop in the value chain.”
With demographics driving the growth of the annuity business and increasingly onerous bank regulations opening up the lending market, Rowan had created something of a financial perpetual motion machine. PR Pro Josh Clarkson of Prosek Partners writing in The Alternative Investor,
“In the years that followed, others saw the attractiveness of this model and launched or bought similar platforms. Many of these originally grew through purchasing existing locks of insurance from insurers looking to reduce their exposure to certain areas, often at attractive valuations given public investors' distaste for these exposures at the time. As the popularity of this strategy grew, the valuations for such blocks, and for annuity platforms, have increased, and now many alts-backed insurers both purchase blocks and originate new organic business through multiple channels.”
Other alternative managers and hedge funds tip-toed into the market, setting up insurance shells to buy the liabilities and earn the spread for themselves, but none had taken the bold approach of fully integrating an insurance business. Simultaneously, the assets dedicated to alternative strategies grew precipitously, again, on the back of falling interest rates.
By 2020, the largest private equity firms had captured virtually the entire pie of institutional assets. Their continued growth depended on finding new assets, and many began looking downmarket to the private wealth channel to attract equity to their products. This strategy admittedly had some low-hanging fruit, but the distribution and investor relations functions were expensive and burdensome for firms that had been built on capital-lite models.
Buying insurance assets was an expeditious way to grow assets with the caveat that only a portion of the capital could be deployed into an alternative firm’s core offering. In essence, every $1 of purchased insurance assets created ~10 cents of new equity for alternative managers, so they needed to buy lots and lots of insurance assets. By contrast, the Apollo-Athene model showed how this channel could be exploited to create 30 cents or more of new equity with each new dollar of insurance assets. Further, the new debt origination platforms you seeded feed investment-grade assets to the insurance capital. An ouroboros of capital flows was hence created where new assets beget new assets in a symbiotic cycle of debt origination.
Sea changes in financial markets are not always obvious. It is now undeniable that open market share buybacks have had an impact on equity markets, but little was made of the adoption of the SEC’s 1982 10b-18 rule that created them. Such, I believe, is the case with the marriage of non-bank debt origination with insurance liabilities. It upends the economic identity that investment is a function of savings. Annuitants forgo traditional savings, therefore increasing their capacity for financed consumption; that consumption becomes the feedstock of debt origination. Increased consumption also creates growth, increasing the demand for debt assets as the resulting capital seeks a home. Financialization, defined simply, is the demand for debt assets in the absence of productive uses of that debt. Debt creation equitized by insurance liabilities is an End State of financialization.
All forms of debt borrow from future growth. When that growth fails to materialize, new debt is needed. As diminished expectations weigh on returns, yields need to be structured to continue to attract capital. Structured finance takes a given yield and then tranches it into a priority of payments, creating higher and lower-yielding securities by breaking risk and reward up into new buckets. The riskiest of those buckets is the equity tranche, which bears the first loss in the event of a payment shortfall. Insurance-led credit origination takes a debt, the annuity liability, and uses a portion of it to serve as the equity of new debt vehicles.
The complexity of this arrangement doesn’t obviate the role of equity; it inverts it. Economically, equity plays a key role in resource and capital allocation. Traditional equity derives its value from corporate performance and its future prospects. It is the “front line” of capitalism. Debt follows equity in this process of capital allocation. Debt is at least partially defined by equity. It is the existence of the junior claim that gives the senior claim its currency.
Equity in the insurance model is more akin to a derivative or an option that derives its value from asset prices and credit spreads. Alternative managers run this equity through a GP/LP structure that further disambiguates business performance from investment outcomes. Under this model, equity exists to serve the creation of debt. Resource and capital allocation are not front-and-center. This form of finance values greater origination volumes both to support asset prices and to feed new assets into the top of the insurance balance sheet.
Marc Rowan, speaking at the Bernstein Strategic Decisions conference in May, said,
“So we go back many years. We were a really large, fast-growing Athene with a smaller origination platform. Athene took 100% of everything. Okay. That was great to start. Now the curves have reversed….And we're doing what you would expect us to do. We're diversifying. Athene does not want 100% of any risk. They want 25% of everything and 100% of nothing. So we built a third-party insurance business, and then we built a third-party institutional business, fixed income replacement business. And you will watch us do this in retail. You will watch us do this in interval funds. You will watch us do this in ETFs. We have a whole interesting world out there, but it all starts with -- the ecosystem doesn't work without origination. That is what is in short supply.”
Rowan conveys clearly what I’ve described above—broadly distributed equity claims that support debt origination. So, where is this all headed? A dystopian view might be a world where there are no savings-funded investments; rather, savers purchase insurance products like annuities. Those insurance products are fed by the debt created from savers’ levered consumption. Equity is created as a result of the insurance product structure and then fed back into the process.
This system undermines the belief that the capitalist system works via the capital allocation feedback mechanism. Asset prices are continually supported by the self-perpetuating demand for debt instruments. In fact, Michael W. Green has pointed out that credit spreads have remained perplexingly tight even as other signs of financial distress have risen.
Without credit contraction, asset price reckoning is forstalled. This reduces the theaters of speculation to corners of the market without debt-driven asset prices -- cryptocurrency, venture capital, and a smaller cohort of traditional equities. Savers are increasingly attracted to instruments that offer defined outcomes that truncate the distribution of returns (insurance products in a different wrapper).
While I understand the temptation to call such a market “unsustainable,” I don’t think it necessarily leads to a dramatic collapse. A more likely path is the continued degradation of returns as malinvestment is allowed to continue for longer.
The classic capital allocation cycle, where booms and busts shift investment to better allocators, is constrained because more “savings” are effectively locked in insurance products. There is definitionally lower volatility, but as an extension, lower returns.
In the fully realized version of this system, there are only two financial functions or roles: Insurance Buyer and Asset Originator. I will leave it to you to decide which is a better proposition.
Disclosures
This report is intended to be educational and entertaining, not investment advice. Do your own due diligence. I make no representation, warranty, or undertaking, express or implied, as to the accuracy, reliability, completeness, or reasonableness of the information contained in this report.
Any assumptions, opinions, and estimates expressed in this report constitute my judgment as of the date thereof and are subject to change without notice. Any projections contained in the report are based on a number of assumptions as to market conditions. There is no guarantee that projected outcomes will be achieved. Lewis Enterprises is not acting as your financial advisor or in any fiduciary capacity.
At the time of this writing, I own shares of Apollo Global Management. My own positioning is subject to change without notice.
This was intense! Had to re read a couple times. Great work as always
This was excellent. And somewhat frightening. Thank you.