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Direct lending investors typically seek stable returns at a defined target level, looking for neither excess returns nor excessive losses. As in public markets, diversification is the simplest and cheapest way to reduce risk within a portfolio. This is even more important for investments such as private debt. Only a handful of managers have track records that precede the GFC, which makes it hard to assess how well a given GP may perform throughout the economic cycle.

In light of private debt’s general illiquidity, using variance of returns to illustrate this point is hardly sensible. To estimate the asset class’s diversification benefits, loss rate and its associated variance are far better metrics. Similar to the public market, the more loans within your private debt portfolio, the lower the loss rate variance for a given target return.

To illustrate the diversification benefits based on the loss rate variance, we used our proprietary database to simulate loss distributions for different portfolio sizes, based on a resampling method like the one used to illustrate section 3.1.3. As one can observe in exhibit 14, the greater the number of loans, the narrower the distribution becomes. The tail risk also diminishes as the number of loans in the portfolio increases.