This article is sponsored by Northleaf Capital Partners
Private markets fund managers have historically focused on individual asset selection as the basis for portfolio construction. While asset-level diligence is at the heart of private credit investing, basing investments solely on the credit qualities of individual assets can result in portfolios that are overly concentrated and exhibit unintended correlations.
Consistent use of portfolio-level tools and analytical frameworks, which are more commonly applied to public fixed-income portfolios, can also inform better investment decisions in private markets. Northleaf has implemented an integrated investment process that combines bottom-up asset selection by deal teams with a top-down portfolio perspective managed by a dedicated portfolio analytics team.
The case for a ‘composite’ risk metric
One of the fundamental challenges that private credit fund managers face is objectively comparing risk, both as between potential investments and within a portfolio as it evolves over time. Northleaf’s first step in building a portfolio analytics framework was therefore to develop a ‘composite risk score’ for each proposed investment. This blends asset-level metrics that are common across our loans to create a building block that underpins a range of further analyses. Combining the composite risk score with details of loan pricing for a proposed investment allows us to assess expected return per unit of risk. This can be used to compare the relative value of new loan opportunities in the investment pipeline with one another and with existing loans in the portfolio. At a broader level, it allows us to evaluate how the overall market pricing of risk is evolving over time. These comparisons support a richer deal team and investment committee discussion of relative value trade-offs, the appropriate pricing level for new loans and market risk trends.
A composite risk score also enables a risk-adjusted view of portfolio exposures. Quantitative analysis of risk exposure for different segments of the portfolio, for example by industry, usually starts and ends with the dollar amount committed to each segment. By weighting exposures to reflect the risk position of each loan and how each is expected to trend, we develop a view of risk exposure that reflects the ongoing performance and trajectory of the investments. This supports a more dynamic risk allocation approach.
As an example, in early 2019 Northleaf observed that the IT services and software segment of its portfolio was ‘de-risking’ at a consistently high rate, with strong organic business performance and reductions in leverage evident across borrowers. A risk-adjusted view of exposures reflecting these considerations provided quantifiable support for a decision to continue to increase dollar exposure relative to other segments. The resulting tilt towards this sector, which features ‘sticky’ service offerings provided on a long-term contract basis, positioned our portfolio more strongly going into what has turned out to be a turbulent 2020.
Identifying ‘pockets’ of risk
The average loan loss rate for private loans has been low over the long term, both in absolute terms and relative to loan spreads. But this obscures the fact that loss rates are highly uneven over time and across portfolio segments.
Although it is easy to identify the drivers of loss clusters with the benefit of hindsight, this is much more challenging when making forecasts. Northleaf is therefore focused on proactively managing risk concentrations wherever we see potential for these to arise. Our portfolio construction objective is ‘targeted diversification’, which reflects a deliberate and moderate emphasis on segments with favourable risk characteristics and seeks to avoid unforeseen correlations between individual assets. While many managers think about ‘first order’ concentration by industry segment and geography, we track and manage concentration across additional dimensions of risk, such as exposure to competition, regulatory change and execution of acquisition strategies.
This has meant thinking through the degree and nature of exposure to covid-19 risk – for example, differentiating face-to-face services impacted by social distancing rules and norms from businesses that see demand curtailed by working/studying from home or are reliant on complex global supply chains.
When Northleaf evaluates geography and industry sectors, we seek to apply a segmentation that gives rise to meaningful insights. For example, the common approach to managing geographic exposure is to attribute each investment to the country in which its corporate headquarters is located.
However, while some mid-market companies are localised, others may have international customer bases. As such, we consider geographic exposure based on where each company generates its revenues, distinguishing borrowers focused on a single region from those that have a multi-region or global footprint. In addition, we view the US as five distinct regions, as the impact of global recessions upon these regions has been as variable as the differences observed across Europe. This has proven beneficial in the context of the pandemic, as a portfolio that is balanced across all five US regions (plus European and global borrowers) limits the potential impact of a concentrated covid outbreak in a specific area.
Organisational design that enables portfolio analytics
While these portfolio-level tools and analytical frameworks are essential, having an organisational structure that enables their application is equally important. Northleaf’s dedicated portfolio strategy and analytics function provides a consistent focus on portfolio considerations, and an independent perspective, which complements the asset-level focus of deal teams. Fostering the right balance between these two parts of the investment team is key – the groups need to be distinct to ensure role clarity and objectivity, but closely aligned to encourage collaboration.
It is also important to be clear about when and how the portfolio perspective feeds into the ongoing investment decision-making process. For example, establishing a regular forum for the portfolio strategy and analytics team to share insights with the broader investment team can help inform deal-sourcing and deal-screening efforts.
We also require that the independent assessment of portfolio fit and relative value from the portfolio strategy and analytics team be included as a part of every deal team investment recommendation. This enforces the discipline that the investment committee explicitly take account of these considerations when making each investment approval decision.
In a market characterised by heightened uncertainty and volatility, sophisticated risk analysis applied to the existing portfolio and new investment opportunities will be an increasingly important factor in delivering superior and sustainable private credit returns. Northleaf’s investment in the portfolio strategy and analytics function illustrates the value of deliberately and systematically combining asset-level credit underwriting and fundamental company due diligence with portfolio-level risk analytics and perspective.
Jon McKeown is managing director, portfolio strategy and analytics, at Northleaf Capital Partners