Diversification in direct lending

In portfolio construction, diversification is paramount owing to its capacity to mitigate risk, particularly in the face of tail events. This is especially true in direct lending, where investors tend to focus on downside protection: Too much concentration in a single borrower can amplify return volatility and cause material negative impacts on the overall portfolio’s performance. A comparable risk exists when a portfolio’s loans are acquired through a single general partner (GP), essentially tethering the portfolio’s outcomes to the performance of that sole GP.

This article employs our proprietary data to highlight the merits of diversification through two dimensions: the number of positions and the number of GPs within a portfolio. We also attempt to assess these advantages quantitatively by utilizing measures such as internal rate of return (IRR) and loss rate distributions. Our findings indicate that a more diversified approach corresponds with less severe tail events.