What is the risk of lending to SMEs?
One of the main risks that is involved when lending to a SME’s is that a company you lent to, defaults. In case of default, it is the lender who assumes the risk and who may loose part of his or her capital. Even then, October Recovery teams always try to collect the late payments from the borrowers through amicable or judicial recovery actions.
Why should you diversify your portfolio?
Having a diversified portfolio is crucial to minimize the impact of defaults on the overall rate of return. Indeed, the interest you get on the sound projects will counterbalance the capital loss on your projects in default. In other words, the more diverse your portfolio, the steadier your return. The less diverse your portfolio, the more likely your return is to fall quickly.
How to diversify and balance your portfolio?
- Lend to at least 100 projects:
Our goal is not to make you lend more money but to ensure that you spread the risk over many projects so a default will not significantly impact your profitability. The ideal portfolio should be made of at least 100 loans to get a stable and positive IRR. This takes approximately 6 months to achieve. We know it can seem long but you can go step by step and an intermediary goal is to lend to 50 projects to reach an average diversification level. For example, if your portfolio contains 10 projects, one default will drastically reduce your internal rate of return, but if you have 100 projects, one default will have smaller impact on your overall return.
- Always invest the same amount of money:
This point is closely related to the previous one. Balancing your portfolio will help you minimize the impact of a default on your IRR. Following our previous example, let’s imagine you lend €1,000 to one project and €20 to 99 projects. Your portfolio of 100 projects is actually poorly diversified: if the €1,000 project defaults, your internal rate of return will be substantially affected. That’s why it is important to always lend the same amount to mitigate risk.
- Diversify across sectors:
Spreading your investment over different industries not related to each other will enable you to strengthen your portfolio. This way, if one sector goes down, the impact on your IRR will be lower than if you put all your eggs in the same basket.
- Internationalize your portfolio:
On October, Lenders from all over the world can help companies from France, Spain, Italy and the Netherlands boost their growth. Investing in different countries is a way to manage risk in case of economic downturn, as each country is likely to react differently. Besides, it enables lenders to benefit from opportunities that do not exist in their own country.
- Have a varied range of ratings:
The Credit Team qualifies the projects based on a scoring model developed by October. The credit score ranges from A+ to C, from high to low creditworthiness. B and C projects would present a higher level of risk and A+ and B+ projects would reflect a more consolidated situation. Risk and return are highly correlated: the higher the risk, the higher the return. Depending on your aversion to risk, you will prefer safer or riskier projects. Lending to projects with different credit scores will help you diversify and have a more consistent return stream.
Nevertheless, you have to understand that a good level of diversification does not guarantee to avoid defaults but it will however lower their impact on your profitability. Even a good amount of diversification cannot entirely protect your portfolio against systemic risk.
How is it displayed in the portfolio?
To see if your portfolio is well diversified, you can check the Diversification section in the Summary tab of your portfolio.
The diversification of your portfolio is represented on a scale of 1 to 5 stars.
Your level of diversification is based on the maximum exposure:
Maximum Exposure = Outstanding capital of your most important loan / Total outstanding capital
From your maximum exposure, we set your level of diversification. A good diversification starts from 3 stars.
To better understand your level of diversification, you can also reduce these levels to the number of projects of the same amount.
- 0 stars = less than 10 projects of the same amount
- 1 star = between 10 and 20 projects of the same amount
- 2 stars = between 20 and 40 projects of the same amount
- 3 stars = between 40 and 80 projects of the same amount
- 4 stars = between 80 and 150 projects of the same amount
- 5 stars = above 150 projects of the same amount.