In recent conversations, we have often been asked to describe HCG’s experience with our asset class: Digital Credit. As one of the longest-tenured investment managers in this space, we have had a front row seat to its evolution from a galaxy far away to mainstream. We have seen how well managed portfolios of digital credit can deliver what we believe are compelling risk-adjusted returns, with low volatility and low correlation to other assets classes. However, we have also witnessed how some capital allocators, attracted to the asset class, are challenged to find clear information on basics. The onus is on us practitioners to educate our audience, so we curated a few key topics:
1. What is Digital Credit?
Digital Credit refers to fixed income assets (e.g., loans) sourced, underwritten, and serviced using financial technology (Fintech), which in turn enables faster and more efficient credit decision-making and processing. Fintech companies, including digital lenders and payment systems, are at the center of this digital credit evolution. These firms harness big data, engineering, and online optimization to provide affordable credit products and an overall superior customer experience, particularly when compared to traditional lenders.
2. Does this asset class span across multiple sectors?
Yes. It includes, but is not limited to, consumer credit in multiple formats (e.g., personal installment, Buy Now Pay Later, point-of-sale), small business loans, student loans, and real-estate mortgages.
3. What are the features of Digital Credit?
Typically, they are small balance, short duration, and amortizing. Small balance refers to the size of each asset being purchased. This could range from a few hundred dollars up to a few million, typically averaging $10,000 per position. Short duration, typically, duration is less than 2 years, refers to the average life of the underlying asset, not its term. Amortizing means that each credit asset is paying down principal and interest in regular installments (like your mortgage); in aggregate, a portfolio with digital credit assets typically receives payments on a daily basis.
4. Why are these features important?
Portfolios with small balance assets generally have a high number of positions, which can lead to substantial diversification. This type of diversification can mitigate the risk of outsized losses driven by overconcentration in a single credit or borrower. Short duration can reduce tail risk, while daily amortization can provide a portfolio manager with ample investment flexibility and optionality because of strong and regular cash flow generation.
5. What does Fintech add to an investment manager?
Above all, Fintech enables transparency. This provides the investment manager with granular views into two critical components: (a) existence – proof that the asset actually exists, and (b) detailed information on the underlying assets and their performance.
6. How do credit originators sell assets to investment managers?
The majority of leading credit originators – in most cases, well-capitalized public and private companies – sell their originated credits programmatically on a passive basis. In other words, investment managers generally do not cherry-pick assets.
In the early days of the asset class, “active selection” (or cherry picking) was the preferred way to invest for one principal reason: it was a source of alpha. Originator underwriting models were still young, and did not always price risk correctly, which allowed an investment manager with a good algorithm to identify and buy mispriced assets. Emerging originators were happy to accommodate active selection to attract investment capital that helped train their underwriting models.
Fast forward to today: Active selection, particularly at scale, is no longer a source of sustainable alpha for investment managers looking to purchase what we believe are the most attractive FinTech credit assets. In our opinion, identifying the right originators and establishing long-term collaborative relationships with them is a lasting source of creating value for investors.
7. These are private assets. How are they valued?
Maintaining an appropriate valuation policy is critical because accounting standards require that private assets are held at “fair market value.” To determine this, an investment manager’s valuation approach should consider expected cashflows from principal amortization and interest payments over the full term of the asset, adjusted for views on future losses and the pace of principal re/pre-payments.
8. Should an independent third party be involved in the valuation process?
Yes. A reputable and experienced valuation consultant should be used to calculate a value range of a portfolio’s credit assets, and in the process, verify the investment manager’s valuation approach, assumptions, and output. Ultimately, the independent party adds important checks and balances to the valuation process.
9. What are some of the risks of this asset class?
Bad actors on both the originator side and the investment manager side could create reputational damage that stunts continued growth in the asset class. Certain credit originators, especially those with limited access to capital and facing existential or extinction risk, may take aggressive decisions that may prove to have negative consequences. Similarly, investment managers can also tarnish the asset class through aggressive marketing tactics, poor valuation policies, and/or opaque portfolios. This is why, in our opinion, picking the right partners is critical to success.
During close to a decade as digital credit specialists, HCG’s principals have watched originators and managers come and go, and learned the ingredients to identify the right digital credit originators and opportunities: