(Bloomberg) -- Advanced Credit Solutions is a tiny finance firm based in Luxembourg that was founded by a Belgian and works with insurers. Despite its outwardly bland appearance, the business it does is anything but.
The little-known outfit is the brains behind Fox Hedge, a roughly $5 billion fund created for Apollo Global Management Inc., according to people with knowledge of the situation. It's a highly complicated investment vehicle that pushes the boundaries of just how creative the titans of private capital can be when putting regulated insurance capital to work.
In recent years Apollo and other peers with private equity roots have been buying up swaths of the life assurance and annuity industry, getting their hands on a mountain of savings. But there's a snag. Using this cash for riskier, more lucrative bets on private credit and similar assets often inflicts hefty capital charges on insurers. And safer harbors like Treasuries and mortgage bonds don't usually offer the returns that fund managers want to entice clients.
As private markets boom, insurers are desperate not to miss out.
That's where Fox Hedge steps in. Working with ACS, Apollo bundled up a smorgasbord of assets plucked from its own funds, including safer assets and racier stuff like real-estate debt, into a Bermuda-based vehicle. They then sold bonds against it with investment-grade ratings and unusually long lifespans.
The plan was to give an insurer private credit-style returns while only having to set aside a fraction of the regulatory capital needed if directly investing in such assets, multiple people with knowledge say. The 40-year final maturity was built to match the needs of an insurance company with long-term liabilities.
Apollo didn't need to go far to find its main buyer. Most of the debt was snapped up by its own insurer, Athene — about 86% of it as of December, Moody's estimates.
The deal goes to the heart of two concerns that are starting to exercise regulators and ratings companies right now: insurers' growing hunger for more exotic, and more profitable, credit wagers; and the implications of so much of the insurance industry being in the hands of private capital — a world known for its tolerance of high-risk, high-reward gambits.
Combining such an assortment of assets in a single vehicle does break new ground, people with knowledge of Fox Hedge say. But they argue it's potentially safer than other bundled debt because the sheer variety of collateral makes its cash flows more reliable. And it contains individual assets that are better rated than those in collateralized-loan obligations, an established way for insurers to buy investment-grade products made up of slices of junk-rated credit.
Still, the maturity on Fox Hedge bonds is far longer than on the assets it uses as collateral, so they'll need to be swapped out over time. Investors are counting on future returns without being sure of where they'll come from.
Fox Hedge pushes the envelope in other ways, too. Although it looks and feels like a securitization — a kind of vehicle that packages debt into bonds — it also has features of corporate debt, which potentially lets it include securitizations as collateral without tripping some countries' rules on re-securitizing assets.
ACS also used the safest cash flows from Fox Hedge, the management fee, as collateral to help pay for its purchase of a chunk of the riskiest part of the structure, the equity, people familiar say. Banco Santander SA helped with that and the fund's creation, according to people with knowledge of the matter.
This story is based on conversations with about a dozen people who know Fox Hedge, all of whom asked to stay anonymous discussing private information. Apollo, Athene and Santander spokespeople declined to comment. Representatives for ACS didn't respond to requests for comment.
Happy Returns
For Athene and its owner Apollo, the appeal of Fox Hedge is obvious. The senior fixed-rate portion has a 6.05% coupon, Bloomberg data shows, while the lower-ranking floating-rate notes are at 7.32% and 8.32%. That's a tasty return on an insurer's regulated capital.
Apollo boss Marc Rowan has shown an interest in the initiative, two people with knowledge of the matter say, and his firm is considering a second similar fund. Fox Hedge makes up a very small part of Athene's overall holdings in investment-grade fixed income, another person adds.
There's incentive for others to try similar. Researchers at the US Federal Reserve reckon insurers could cut capital charges by a factor of 10 by replacing direct-loan holdings with investments in vehicles containing the same loans.
Any successful model for long-duration credit would be catnip, too.
The 2064 final maturity on the main portion of Fox Hedge's debt is far longer than nearly all other non-government investment-grade assets. That satisfies some of Athene's vast needs, but it adds risk because of the fund's need to swap out shorter-term assets as it ages. Athene will have power of approval for any future collateral, says a person with knowledge of the fund.
"All financial innovation is generally there to solve a problem," says Andrew Lo, director of the Laboratory for Financial Engineering at MIT Sloan School of Management. "If you've got some long-dated obligations, you want long-dated assets to mature and pay them off."
Lo, speaking generally and not about Fox Hedge, adds that complex ways of engineering long-dated investments could end up creating their own problems if they become common.
Sliced and Diced
While ACS founder Alexandre Kartalis doesn't have much of a public profile, he did pop up in a British court ruling from 2019 on a commercial dispute involving an outfit called Blackstar Advisors and hedge fund Cheyne Capital. According to documents, Kartalis played a part in a complicated deal between the two firms involving pension money and special-purpose vehicles. In his witness statement, he said the deal included a "long-term commitment" of "substantial funds."
The ACS website says he also once had roles at Swiss investment banks UBS Group AG and Credit Suisse — and that he's a former shareholder of Harbourmaster Capital, a European loan and CLO manager that was sold to Blackstone Inc.'s credit business.
People familiar with Fox Hedge say it has elements of how you'd assemble a CLO and other structures such as collateralized-fund obligations, which slice and dice PE portfolios into bonds, many with investment-grade ratings.
Apollo placed assets from several of its funds — including CLOs, asset-backed securities, direct loans and corporate credit — as well as equity stakes in Apollo funds, in an SPV. The vehicle issued senior and junior notes backed by the assets' cash flows.
Fox Hedge's debt was privately rated with grades that reached as high as AA-. Bloomberg data shows that a significant portion of the senior debt was bought by Athene through funds managed externally.
Apollo kept a portion of the unrated equity slice that makes up the riskiest bit of these kinds of instruments, according to people familiar. Having Apollo, and not Athene directly, keep that portion let the insurer avoid the onerous capital charges that stem from holding poorly protected assets, they say.
Private Party
Although there's some recognition that insurers can't afford to sit out the relentless rise of private credit, some are troubled by the exotic ways in which they're investing. The Fed has noted a shift in "portfolio allocations toward risky corporate debt, while exploiting loopholes stemming from rating agency methodologies and accounting standards."
Moody's calculates that the US life insurers with the largest exposures to private credit tend to be tied to alternative-asset managers, like Apollo's Athene and KKR & Co.'s Global Atlantic. It notes that insurers are starting to hold big exposures to single borrowers, name-checking Fox Hedge as an example.
Overall, the ratings firm estimates roughly a third of US life insurers' $6 trillion cash and invested assets is already tied up in various forms of private credit, and the share's rising.
Some market participants say they're less worried by Apollo pioneering more complex products for insurers, even its own, and are more bothered about copycats with less financial muscle and expertise trying similar.
As usual with private markets, regulator anxiety stems chiefly from questions about how you might value rarely traded assets. Bundling them can make it tougher to track.
"Even with very transparent, inconsistently liquid assets, it can be difficult to accurately determine true prices," says Ken Froot, professor emeritus at Harvard Business School. "With illiquid assets that aren't just opaque and complex but also have very long durations, it's much harder."
(Updates in fifth paragraph from the end with Moody's findings on US life insurers with largest exposures to private credit.)
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