How Credit Lending Asset Management Firms Can Manage their Risk

By Scott Roberts

Credit focused lending offers many unique investment opportunities. Whether loans, leases, or advances, there are many different types of investment opportunities directed to both consumer and commercial borrowers. The origination of asset backed loans offers clients greater cash flexibility, yet still provides the firm with appropriate collateral. While asset backed lending offers great benefits to both the firm and its clients, this profitable strategy does not come without some risk. This article will highlight some notable risks this type of asset management firm faces, as well as effective ways to address these risks.

First and foremost, credit lending firms need to consider the credit risk they are exposed to. In their very nature, they are taking on risk when they lend cash to their clients. Realistically, not every client is going to be able to repay the loan, and this poses a serious risk to the firm. A common practice used to address this risk is considering “The Five C’s”: capacity to repay, capital, collateral, character, and conditions of the loan. Essentially, firms need to require sufficient collateral based on the client’s creditworthiness and capacity to repay. Furthermore, it is also strategic to require more liquid collateral for less creditworthy clients. This way, if the client defaults, the firm will quickly receive assets equal to or greater in value than the loan amount, making up for the client’s failed repayment. A “C” that is often forgotten, but just as important, is character.[1] Sometimes, the character of a borrower can be more telling than their financials. Consequently, it is important their character is considered in addition to how they appear on paper.

Building on the credit risk of their clients, these firms also face great exposure when it comes to liquidity risk. As mentioned above, firms should carefully select the collateral they back their loans with. In particular, firms should prioritize securing collateral with high liquidity such as stocks, bonds, and treasury bills. If less liquid collateral is used, such as land, buildings, or equipment, the firm should adjust the terms and conditions of the loan so that the loan amount is lesser than the book value of the assets used as collateral.[2] In other words, when illiquid collateral is used, firms should loan less money than what the collateral asset is worth. Adjusting the conditions of the loan in this manor accounts for the extra risk associated with the longer time period required to absorb these less liquid collateral assets.

In addition to strategic lending habits, management firms need to consider combating the risk inflation poses to their portfolios, especially in times like this when inflation is on the rise. Historically, inflation is “most susceptible to spiking when wages are increasing substantially relative to labor.”[3] Given the recent increases in wages and sign on bonuses, combined with the “disinterest of the workforce,”[4] the risk inflation poses is as relevant as ever. In turn, t is critical these firms are investing in diverse assets that hedge effectively against increases in inflation. These inflation hedging assets can take form in many different ways.

These inflation resistant assets can look like oil, coal, cryptocurrency, fine wines, art, baseball cards, vintage cars, EFT’s, and other collectible items. By strategically diversifying their portfolio to this elite level, firms can better protect and grow their portfolios.

When considering all the risks a management firm faces, it is important to understand risk isn’t necessarily bad. Society has given risk a negative connation, yet taking on risk can lead to great profits, just as it can lead to great losses. Strategies to avoid, mitigate, and share risk are frequently advised, yet accepting risk is often an overlooked strategy. In certain situations, accepting risk might actually be necessary for a firm’s success. Therefore, it is important to understand when and how firms should accept risk rather than mitigating it. For instance, it is important to consider the timeline and investment goals of a client. If a client has a high growth goal over a short timeline, it might require a riskier selection of investments rather than a diversified selection. Furthermore, consider lending to a business with a terrible credit score from Dun & Bradstreet. At first it might seem counter intuitive to take on the risk of lending to a uncreditworthy company, but if you are lending under the terms of a blanket lien, you could end up absorbing a plethora of the company’s assets. Sometimes, accepting risk makes sense, and provides great payoffs. Learning the discernment of when to accept risk like this is fundamental to becoming a great investor.

Understanding the different types of risk a firm faces is important, yet it is even more important to know when and how to handle these risks. It is critical firms exercise strategic judgement when it comes to mitigating, sharing, avoiding, and accepting these different types of risk, especially when they are lending out cash. If an investor races to master risk, rather than running away from it altogether, they will become an invaluable asset to their firm.

[1] “Loans and Lending”, National Funding, October 14, 2015, https://www.nationalfunding.com/blog/the-6-cs-of-applying-for-a-business-loan/ [2] Julia Kagan, “Asset Based Lending”, Investopedia, May 15 2020, https://www.investopedia.com/terms/a/assetbasedlending.asp [3] James Montier, “Inflation - Tall Tales and True Causes”, GMO, August 12, 2021, https://www.gmo.com/americas/research-library/part-1-inflation--tall-tales-and-true-causes/ [4] Matt Smith, “More Strikes Are on the Way”, Barron’s, October 15, 2021, https://www.barrons.com/articles/strikes-unions-worker-shortage-51634153832?mod=hp_LEAD_3