Diversifying private credit portfolios: beyond traditional metrics
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"Diversification is the only free lunch in finance"
– Harry Markowitz1
Many recent conversations with LPs have centered around the growing sense of crowding and concentration in the private credit market, prompting a revaluation of exposure and portfolio metrics. With that in mind, we wanted to spend some time this quarter diving deeper into our approach to diversification.
Beyond traditional diversification metrics
Beyond traditional diversification metrics
Diversification has long been a pillar of investing. However, in today’s markets, capturing its benefits requires looking beyond well-known metrics such as the number of positions, percentage limits, seniority in the capital structure, equity versus debt allocations, sectors, and geographies. The initial layer of diversification for many investors over the past five years has been expanding into private markets to offset public market exposure. Yet, as allocations to private markets grow in pursuit of attractive returns, lower volatility, and increased diversification, investors should consider how they “diversify their diversifier.”
The private equity link in private credit
The private equity link in private credit
Within private markets, there’s been a notable emphasis on diversifying private equity exposures by investing in private credit. An important caveat that is often overlooked when investors allocate to private credit though is that the vast majority of private credit portfolios are comprised of loans made to companies owned by private equity sponsors. In short, upper middle market direct lending is almost always just the senior part of the capital structure in deals orchestrated by top private equity firms. This scenario means that, lenders are often exposed to the same sponsors, companies, and industries that investors aim to diversify away from.
Concentration risks in private credit
Concentration risks in private credit
This concentration to private equity is exacerbated when considering the substantial capital raised among the top-20 mega-private equity and private credit firms, which often invest in each other’s deals. The sheer volume of private credit capital linked to a relatively small number of private equity firms makes it challenging for investors to avoid concentration in:
- sectors favored by large private equity sponsors, such as services, technology, and healthcare
- high debt-to-adjusted EBITDA loans that are fundamental to the private equity model,
- weak credit documents that private equity sponsor lawyers insist lenders sign because they are “market” (market refers to terms and conditions that are currently accepted in the industry. However, these market terms may include fewer lender protections, such as reduced covenants, which can increase risk)
- capital markets functioning to provide exit options for equity through M&A/IPO and refinancing for debt.
Notably, while these features are endemic to most large private equity-linked deals, none are credit-positive. Consequently, private credit investors in these deals may face a “double whammy” of concentration and credit negatives.
Strategies for effective diversification
Strategies for effective diversification
Navigating around these pervasive pitfalls will require investors to be more granular in their analysis of private credit strategies when seeking to diversify their portfolios. Specifically, to capture the benefits of diversification, we believe investors should look for the following features in a private credit portfolio:
- non-sponsor and sponsor ownership
- corporate lending and asset-based financing
- broad and balanced sector and asset exposure
- conservative position sizing
- multiple geographies
Understanding correlations
Understanding correlations
As investors sharpen their focus on diversification, additional nuances will come into view. For instance, correlation, closely related to concentration, becomes a critical component of the analytical framework. In the past few years, among private credit firms that provide significant leverage to large sponsor-owned companies, one can see strong correlation of performance to rates, capital markets and recessions. These correlations appear to be less pronounced among non-sponsor focused managers due to lower leverage and a broader spectrum of sectors and assets.
The importance of detailed analysis
The importance of detailed analysis
Since superficial analysis can mask certain correlations, investors should engage managers in discussions about correlations within their portfolios — even in seemingly unrelated exposures. For example, a company providing technology services to the healthcare sector may be labeled as a "Healthcare" transaction but also correlates with factors influencing the technology and services sectors. In other instances, sector classification may suggest correlation where none exists. For instance, two companies classified as "Financial Services > Specialty Finance > Consumer Finance” may have very different performance drivers, necessitating a nuanced understanding of their respective correlations.
Thoughtful implementation
Thoughtful implementation
As the narrative of expanding private credit options — such as asset-based financing, lower middle market, and non-sponsor lending — gains momentum in 2025, the burgeoning awareness of private credit’s concentration to private equity and it’s knock-on effects alert investors to the need for deeper consideration of diversification within their private credit portfolios. The bottom line is that if you are focused on concentration and correlation as risk factors in your portfolio, it is essential to think several layers down about diversification and to thoroughly understand where hidden correlations may exist.
As Nobel laureate Harry Markowitz famously stated, “Diversification is the only free lunch in investing”. However, it’s crucial to recognize that while diversification is well-intentioned, its effectiveness depends on thoughtful implementation. Superficial diversification may not provide the desired risk mitigation, underscoring the importance of a strategic and nuanced approach to portfolio construction.
A robust approach to diversification ensures portfolios are not only better positioned to withstand concentrated risks but could also perform more effectively in an uncertain and evolving future. By looking beyond surface-level metrics and understanding the deeper intricacies of diversification, investors can build portfolios that are more resilient and adaptable to changing market dynamics.
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