What is the risk of lending to SMEs?
The risk is that a company to which you have lent defaults. In case of default, it is the lender who assumes the risk and who may lose a part of his or her capital.
Diversification: the only strategy to protect you against the risk of capital loss
Diversifying your portfolio is very important, as it's the only strategy that allows you to minimize the impact a default can have on your global profitability. If your portfolio is poorly diversified, your profitability is more likely to fall in the event of a default.
The diversification of your portfolio is represented on a scale of 1 to 5 stars.
Having a diversified portfolio is crucial to minimize the impact of defaults on the overall rate of return. 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.
A simple example:
- if your portfolio contains 10 projects at € 100 (€ 1000 total), one default will have a significant negative impact on your rate of return;
- if your portfolio contains 50 projects at € 20 (€ 1000 total), one default will only slightly decrease your overall return.
Your level of diversification is based on the maximum exposure:
Maximum Exposure =
Outstanding capital of your most important loan
/ Total outstanding capital
- if you lend to 100 projects, € 1000 to the first one and then € 20 each time for the followings, your maximum exposure is 1000/2980 = 33%.
This means that your portfolio composed of 100 projects (which at first glance could look like a well-diversified portfolio) is actually poorly diversified: if the €1.000 project defaults, your internal rate of return will be substantially affected.
From your maximum exposure, we set your level of diversification. A correct 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.