Private credit's risk hides in insurance company ratings
Private credit has poured into insurance companies, much of it in affiliated investments, rated by private agencies that are systematically too generous; on correct ratings, insurers would have to hold an extra $400-500 billion of capital a year.
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A stock fund should be 80-90% stocks
When Bob Posen took over as Fidelity's president in 1995, the firm was in an awkward spot: Jeff Vinick had moved half of the Magellan fund into cash, which both dragged on performance and violated holders' expectations of a stock fund. His approach was to build internal consensus first — if you run a stock fund, you must keep 80% to 90% of the position in the kind of stocks the fund's name implies; if you want balanced, if you want a money market fund, the firm has other products. His logic: investors bought this fund's stated positioning, and a manager cannot change that positioning just because he thinks "now is not a good time to buy stocks." That rule later became basic discipline for Fidelity's stock funds.
— Bob PosenAfter doubling in size, keep the startup feel by splitting into small teams
Under Posen, Fidelity's assets under management grew from $500 billion to $1 trillion. His judgment was that the key to managing that much money is not process but how to preserve entrepreneurial spirit and a sense of belonging. The method was to split the investment team into relatively small groups — value, growth, small cap, international and so on — giving each group a stronger sense of ownership over results. At the same time he consolidated money market and bond funds in New Hampshire, because fixed income and money market funds look at the same credits, and here scale is a friend that spreads out enormous economies of scale; stock funds are exactly the opposite.
— Bob PosenPut private equity in 401ks, but cap it at 10-20% first
Posen is reserved about putting private equity into 401ks. The core problem is liquidity: if a participant puts all their retirement assets into a single private equity fund, they simply cannot get the money out when hit by a medical emergency or when they reach the age for required minimum distributions. His proposal is that private equity should only be part of an asset-allocation fund or a target-date fund, not a standalone option; if it must be a standalone option, employers should set a cap, and the order of magnitude he gives is 10% to 20%. He draws an analogy to employer stock: GE employees who put their whole 401k into GE stock did not end well, and a retirement account needs diversification.
— Bob PosenThe instant markup in secondary trades is an accounting loophole
Private equity is hard to value to begin with, and what worries Posen most is secondary trades: a private fund, needing to raise cash or nearing the end of its investment period, sells part of its portfolio at a discount to another private fund. There is a technical loophole in the accounting rules that lets the buyer immediately mark that investment up to par on its books even though it bought at, say, a 5% discount. He believes this rule must be changed. Valuation is already hard enough; this "instant markup" should not be allowed to lift book value out of thin air and pass it through to holders via NAV.
— Bob PosenPrivate ratings systematically overstate private credit
The private credit held by insurance companies, depending on how you count, can reach as much as $2 trillion, and a large share of it is "affiliated investments" — starting with Apollo, more and more private equity firms have become owners of insurance companies and then placed debt related to themselves into their own insurers. Posen and his co-authors found that a great deal of private credit is rated by private rating agencies, and that rating shopping exists. Two studies, from Columbia and Imperial College, show these private ratings are systematically too high; on correct ratings, insurers would have to hold an extra $400 billion to $500 billion of capital a year. His solution is direct: make the private ratings public and let the market pick apart the assumptions and methodology.
— Bob PosenMark Walter's $20 billion of affiliated credit is a wake-up call
Posen treats the Mark Walter case as a wake-up call. Walter founded Guggenheim and figured out early that buying a life insurer lets you steer what was a conservative insurance portfolio into higher-yielding securities, including private credit related to Guggenheim or to your own portfolio companies. The rules themselves allow insurers to invest in affiliated private credit, provided it is disclosed to regulators. Regulators have now found that insurers controlled by Walter or Guggenheim hold about $20 billion of affiliated private credit, some of which may have been used to buy the Los Angeles Dodgers and the Lakers. Walter's side is trying to divest part of the affiliated credit. Posen stresses this is not just Guggenheim: large private funds such as Apollo and KKR have all found insurance companies to be handy investment vehicles.
— Bob PosenSomeone with $1 million investable should not hold 40% bonds
Posen points out that most target-date funds arrive at retirement at 80% bonds and cash, 20% stocks, which is reasonable for people who must live off their retirement portfolio. But more than 7 million Americans have investable assets (excluding their primary residence) of over $1 million; they do not live off investment income and can ride out a down year in stocks. He calculates that over 30 years, a 60/40 portfolio and the 90/10 he advocates (90% stocks, 10% cash) differ by a factor of two in terminal value — the equivalent of $5 million versus $2.5 million. He rebuts the objections one by one: over the past 60 years bonds acted as a hedge in only 10 of them; in 2022 stocks and bonds both fell about 18%; stocks fall deeply, but look at two years, five years — after 2008, 2002 and 1974 they recovered and surpassed.
— Bob PosenSemiannual reports are fine, but don't scrap first- and third-quarter filings
Posen supports keeping quarterly reporting and opposes moving to semiannual. The reason is that the economy, diplomacy and a company's own circumstances all change fast, and six months is a long time; moreover, the information vacuum created by semiannual reporting encourages insider trading. His compromise: full 10-Qs and 10-Ks at mid-year and year-end, and a slimmed-down report in the first and third quarters — three or four pages plus the income statement and balance sheet, not a heavy burden. He rebuts the claim that "less reporting encourages long-termism": when the UK made the move from quarterly to semiannual reporting optional in 2013-14, he and a quantitative accounting scholar at Columbia compared the two groups of companies, and the firms that switched to semiannual did not invest more in R&D or capital expenditure.
— Bob PosenIn their own words · checked verbatim
Meaning every event that happens in the world, he translated into what it means for stocks.
Bob Posen1:04
There is a a technical glitch in the accounting rules that allows that buyer even though they bought at say a 5% discount to mark up that investment on their books immediately to par.
Bob Posen22:26
And we now have two studies, one out of Colombia and the other out of uh Imperial College in Indiana, which shows systematically these private ratings are giving private credit too high a rating.
Bob Posen25:30
So the solution is is pretty clear. Let's have those private ratings published.
Bob Posen26:33
But, uh, private credit, what did I title that article? Private ratings for private credit is a dangerous combination and I stuck by that.
Bob Posen33:38
I've calculated these numbers and over 30 years uh the difference between a 60 port 40 portfolio with 40% in bonds and 60% in stocks and what I call a 9010 portfolio 90% in stocks and 10% in cash uh is double.
Bob Posen43:55
And as my wife said, who's a psychotherapist, uh, six months is not the long run.
Bob Posen52:12
And my view is bonds are a bad deal.
Bob Posen55:16
Figures
| MFS assets under management (when Posen was executive chairman) | about $130 billion | 10:13 |
| MFS assets under management (when Posen retired) | close to $400 billion | 12:15 |
| Private credit held by insurance companies | as much as $2 trillion depending on how you count | 23:26 |
| Additional capital insurers would need to hold each year after rating corrections | $400-500 billion | 25:30 |
| Insurance and private credit holdings tied to Mark Walter | about $20 billion | 28:34 |
| States that have set up state-level auto-IRA plans | 17 | 38:48 |
| Americans with over $1 million in investable assets | more than 7 million | 42:52 |
| Projected Social Security insolvency year and automatic benefit cut | around 2033, with benefits automatically cut about 23-24% | 36:44 |
Glossary
- private credit
- Debt that is not publicly traded and is lent directly by private firms, with poor liquidity and hard-to-value positions.
- affiliated investments
- Debt held by an insurance company that is related to its parent or an affiliated party.
- rating shopping
- An issuer picking, among several rating agencies, the one that gives the highest rating.
- auto-IRA
- A retirement savings plan set up by a state government, with employers only handling payroll connection, that employees can opt out of.
- reversion to the mean
- The tendency of extreme performance to swing back toward the long-run average.
How to listen
Investors and risk professionals watching private credit, insurance balance sheets and retirement policy; also suited to anyone wanting to understand why active management struggles to beat the index.
The opening chit-chat about Peter Lynch and the Buffett lunch can be fast-forwarded.