Blue Elephant Capital Management

Marketplace Lending & Asset Allocation – Where Does It Fit?

I had the honor and privilege of attending a very prestigious ceremony this week – my 5 year-old’s graduation from his Pre-Kindergarten class. There were no valedictorian speeches or words of wisdom from Nobel laureates, just a bunch of tiny humans singing songs and generally acting like 5 year olds do. While it was most likely something my son will have forgotten by his next birthday, my wife cried like it was his college graduation ceremony.

In truth, graduations like these are significant life markers. We need markers in time to remind us how quickly things change and the corresponding need to adapt. I’m not sure the graduates always grasp the meaning – or that they need to. The important part is that the world is officially put on notice to treat these individuals differently going forward based on their achievements. At the same time, as is especially relevant for the Pre-K crowd, the graduates still have plenty more to learn.

I started to wonder — if we use graduation to mark the passage of time, what other mechanisms do we use once these life events stop happening? In finance we like to mark time via “the crisis”. The 2008 experience is now called The Great Recession. We use markers like 2008 to “graduate” to new ways of thinking about the market based on lessons learned from the experience. Such a graduation requires revising common assumptions around optimal asset allocation strategies.

While we all learned lessons from 2008, I’m afraid that the general approach to asset allocation has not changed. When investors log onto their brokerage accounts to invest money, they are faced with an almost infinite array of choices, ranging from individual bonds and equities to mutual funds and ETFs of astounding variety. However, a closer look at the choices available reveals the sad truth – that really, investors have a choice to own bonds, stocks, or cash. That there are many varieties helps muddy the waters, but it doesn’t make for better or smarter asset allocation choices. Even sophisticated asset allocators such as pension funds and endowments fall into the same traps.

As a manager of an emerging asset-class, I am often asked where direct lending fits into broad asset allocation. The direct lending asset class has many similar characteristics to traditional fixed-income. Each loan can be viewed as a bond, with a stream of interest and principal that will be repaid according a schedule. The risks involved are related to interest rates and business cycles. If you make a loan at 10%, and the interest rate you could make the same loan at tomorrow is 15%, you’ve lost out on some potential income. If the economy turns down and the borrower cannot repay you, the income stream may disappear.

There are some major differences that we need to be aware of. Fixed-income securities are generally liquid, meaning that individual securities can be traded either directly, or via a mutual fund or ETF. For that privilege, investors accept a lower return than for an illiquid asset. Direct lending, on the other hand, is not something that can easily be traded in the market. A second difference is in sheer quantity – a typical bond fund may have a few hundred line items, while a direct lending fund will own thousands of small loans.

Generally speaking, the direct lending option looks like a short-duration bond fund (a bond fund with very little interest rate risk) with a much higher yield than other widely accepted options. While it is true that many of the technology-based originators of these loans have not been tested through a business cycle, FICO scores have been around for a long time. By employing a manager with deep fixed-income knowledge such as Blue Elephant, investors can build in another layer of defense against overly aggressive lending.

Where then does direct lending fit into an asset allocation? It isn’t quite a cash substitute since it cannot be immediately sold. It isn’t an equity allocation simply because it doesn’t show the upside or downside volatility of stock markets. I think it makes the most sense as an alternative to traditional fixed-income, especially higher yielding bond funds or the always dangerous “go anywhere” bond funds that have become so prevalent as yields have fallen.

Having lived through 2008 as a fixed-income portfolio manager, I graduated with scars, but also with an appreciation for the value of diversification. While the direct lending asset is new for most investors, it has enough characteristics of fixed-income to understand its place in a portfolio.