When we first began looking at private lending as a possible investment for our families and clients, we took some time to get comfortable with the risks involved. By expanding our due diligence process and working with experienced partners, we were able to better understand the asset class and the underlying drivers of returns.   

We now favour private lending as a fixed income alternative and source of yield in a world of low interest rates. Following the financial crisis of 2008, receiving fixed income without taking too much risk, by either placing cash in a bank or buying short-dated government or corporate bonds, no longer exists. Therefore, we navigated the various available investment strategies in search of low risk, fixed income.
You can buy equities to receive dividends. However, you’ll face the same kind of market risk as with a long-duration bond portfolio and the risk of losing a large part of your portfolio in a market correction seems too high. There are of course ways to hedge this risk, but this is also very expensive.

There’s real estate, but there are two problems with this strategy: illiquidity and market risk. This is particularly problematic, as both risks tend to occur simultaneously and could therefore also entail significant tail risk.

Then there are credit trading strategies, but again they either carry the same risks as the previously discussed strategies or rely on market and trading conditions to generate returns.  

We discovered relatively quickly that the capital markets may have changed after 2008, but the world kept on functioning and business went on. In other words, there were still people with capital and there were those in need of financing, and that combination meant that there had to be other means of putting the two variables of the equation together - the world of private lending.

In 2009, we began allocating directly to private lending strategies in the UK, and in 2016 we structured a fund that would give our families and clients exposure to a diversified portfolio of lending strategies.

Performance 
We like the risk-return characteristics of private lending against the rest of our portfolios; the strategies that we allocate to have never had a negative year and are very consistent. Default risk is low, volatility is low, and performance has been on the high end of expectations at 5.5 per cent (annual yield) for the duration we sought (less than 12 months).  

Of course, with private lending opportunities, you must ensure that the ones you select are of a high quality and you have a clear understanding of the risks. Our private lending investments are selected if they successfully complete our rigorous due diligence. It can take up to six months for an investment to go through this procedure.

We begin at a very broad level and filter strategies as to whether they fit our basic criteria. We investigate if the strategy is in fact exposed to short-duration loans. We also make sure that the loans are fully secured by collateral and that the manager has an institutional set up. We look at the redemption terms of the strategy and compare it to the tenor of the strategy’s loans. This allows us to understand if the strategy has an asset-liability mismatch. Such kind of mismatch is inefficient and dangerous because in the event of a large redemption we may not be able to withdraw our money in the expected time frame, as the average underlying loan tenors far exceed that of the redemption terms time period. This first filter results in 99 per cent of lending strategies falling short of our requirements.

Next, we conduct deeper due diligence on the strategy, manager and the businesses behind them. We gather further insight on various topics such as the investment process, who the key people are, and how they construct their portfolio. We also collect data on past transactions, loan recoveries and defaults. From the analysis of this material, we produce an initial decision as to whether due diligence on this particular strategy should be moved to the next stage or if it should be thrown out.

If the strategy passes, we conduct on-site visits and meet with the manager and key personnel to discuss a diverse set of requirements, for example the concentration (i.e. the percentage of assets under management held by the largest investors) and alignment of interests (i.e. if the principals are also invested in the strategy). This step ensures that the business and strategy are actually doing what they say they are. Furthermore, it allows us to check against any fraudulent activities and to assess whether the quality of their operations is of an acceptable and institutional level.

Once all the data has been consolidated and we understand all the key points, issues, strengths and weaknesses of a potential investment, the final step is for the Investment Committee to review and approve the strategy or not.

A promising future for private lending 
In the long term, we see allocations continuing to rise in private lending and believe that there is sufficient capacity in this asset class. We are always looking for new opportunities in order to further diversify our portfolio for our clients. We look for investments that will give us exposure across different types of collateral, credits and regions.

Our clients really like private lending and use this investment to “match their liabilities” and keep up with rising inflation whilst interest rates remain near zero. Others are utilising it to finance their mortgage repayments on a property, or other project financing activities.  Some of our clients are also moving their monies out of equities - given that many see equities as currently over-priced and therefore risky - and into our private lending fund.

As more and more capital is looking for yield and with many new strategies coming on line, we believe private lending will continue to grow as an asset class and attractive fixed income alternative.