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, making investments based 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 the private market context. Northleaf has implemented an integrated investment process that combines bottom-up asset selection undertaken 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 out 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 to one another and to 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 further weighting exposures to reflect the latest risk position of each loan and how each is expected to trend in the future, we develop a view of risk exposure that reflects the ongoing performance and trajectory of the underlying investments. This supports a more dynamic risk allocation approach rather than adhering to fixed exposure targets by segment.
As an example, in early 2019 Northleaf observed that the I.T. 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 across the private loan universe has been low over the long term, both in absolute terms and relative to loan spreads. However, as tends to be the case with averages, this obscures the reality 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 ex ante. 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 (e.g. exposure to competition, regulatory change, reliance on execution of acquisition strategies, etc.).
In the current environment, this has meant thinking through the degree and nature of exposure to coronavirus 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 that are reliant on complex global supply chains (this latter factor has proven less of a concern than initially feared).
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 localized, 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 United States as five distinct regions, as the impact of global recessions upon these regions has been as variable as the differences observed across European nations. This approach has proven beneficial in the context of the COVID-19 pandemic, as a portfolio that is balanced across all five U.S. regions (plus European and global borrowers) limits the potential impact of a concentrated COVID outbreak in a specific area.
Organizational design that enables portfolio analytics
While these portfolio-level tools and analytical frameworks are essential, having an organizational structure that enables their application is equally important. At Northleaf, our dedicated Portfolio Strategy & Analytics function provides a consistent focus on portfolio considerations, and an independent perspective, which complements the asset-level focus of the 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 and a ready exchange of viewpoints.
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 & 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 & 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 characterized 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 & 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.
Managing Director, Portfolio Strategy & Analytics
Jon oversees the portfolio construction, risk management, analytics and research that support Northleaf’s private equity and private credit funds and product development activities.