With volatility roiling many traditional markets in the first half of 2022, it is a good reminder that private debt often demonstrates a low correlation with traditional asset classes. That means private debt has the potential to provide important diversification effects for investment portfolios. Pedro Carvalheiro, Head of Investing at CrossLend, explains the reasons for private debt, notably, why European SME loans can provide a basis for highly granular investment portfolios when drawing on the expertise of specialised asset managers.
Looking back at the first half of 2022, no doubt investors have faced significant volatility across equities and fixed income securities, in the face of increased economic uncertainty, inflation, rising rates and the war in Ukraine.
Yet declines in 2022 may also be seen as a natural correction against some of the speculative excesses seen in the last few years, arguably enabled by
central bank policies, including quantitative easing. Specific market sectors, including technology and ‚meme‘ stocks, stand out as symptomatic of these excesses.
The embrace of these sectors was not limited to retail investors – even seemingly conservative institutions such as pension funds engaged in highly risky investments in cryptocurrencies or crypto companies, some of which may have already soured.
I would argue that for these particular institutions, it may be interesting to pursue a strategy of seeking a steady flow of return, such as from direct lending or SME loans, rather than one of pursuing high yields against the backdrop of high risk. Perhaps this boom-bust cycle will be a good reminder of the opportunities in private debt and the diversification benefits it can introduce into a balanced portfolio.
Private debt not only exhibits a historically low correlation with traditional assets in the analysis carried out by CrossLend but also contributes to the real-world economy, such as through funding employment growth, entrepreneurship or the Green Economy.
Adding uncorrelated asset classes, such as private debt, to a traditional portfolio should help reduce the volatility and smooth the returns achieved.
Reducing the sentiment impact
From our experience, a portfolio of investments in European small and medium enterprise (SME) loans – encompassing working capital loans, trade finance and other similar instruments – exhibits a very low correlation with the traditional asset classes, including European high-yield bonds, leveraged loans and investment-grade bonds. According to our analysis, over the last few years, the correlation of the SME loan portfolio with these aforementioned assets was close to zero.
Looking at this on a functional level, a big reason for the low correlation is the fact that private debt is often less liquid than traditional assets. This characteristic shields the asset class from being bid up due to speculation, but then neither do investors sell off their positions due to negative expectations for the future, insulating the asset class from the high volatility and sentiment-driven reactions we see in some other asset classes. (Additionally, central banks did not buy these SME loans under their asset purchasing programmes, meaning asset values or credit spreads were not directly distorted.)
The main factor affecting the pricing or the valuation of this kind of portfolio is the actual behaviour of the underlying loans, namely defaults. That means a portfolio value is expected to remain steady over time if there is no real economic distress. So in this regard, it stands apart as an asset class. Overall, we believe that well-constructed and well-diversified private debt portfolios can help investors reduce their specific or non-systematic risk.
Naturally, systemic or market risk, such as a recession or a war, cannot be avoided or decreased simply through diversification. Still, due to the SME sector’s importance to the whole economy, this asset class is typically one of the first to be supported by governments during such distress periods (as it was possible to observe during the Covid-19 period).
Why SME lending looks attractive
At CrossLend, we see activity in the SME lending space as having the potential to provide investors steady risk/returns while providing diversification benefits to their portfolio, whether or not they have existing investments in private debt or private credit.
One reason is granularity, which can be achieved due to SME loans‘ relatively small ticket size. This feature allows for the construction of portfolios with large numbers of individual exposures compared to the rather concentrated portfolios often seen in mid-cap direct lending strategies.
Additionally, investors can build highly diverse portfolios across different countries, economic sectors (via NACE classification), borrower risk classes, and across different originators, helping reduce the chance of specific or idiosyncratic risks impacting the overall portfolio performance.
Loans to this segment also tend to be amortising, implying a shorter duration than bullet loans, with the amortised capital able to be reinvested at the current market rates, and according to the appropriate credit standards (reflecting the existing risk environment).
Apart from the potential diversification benefits, it’s essential to underline the value that SME lending brings to the real-world economy. SMEs are the engine of job creation in Europe and have significant financing needs which banks cannot fully meet. Moreover, over the past decade, banks‘ deleveraging has essentially opened up this asset class for institutional investors, who may invest in highly granular credit portfolios via digital lenders or funds.
In this context, we see specialised asset managers using data-driven deployment strategies as having an edge, with most institutional investors likely to benefit from their know-how and specialisation in the SME private debt space.
You can find the full article as a PDF here.