Re-examining Modern Portfolio Theory: Volatility, Risk, and the Value of Private Debt with First Lien Properties

Modern Portfolio Theory (MPT), developed by Harry Markowitz in the 1950s, revolutionized investment strategies by emphasizing the relationship between risk and return. A cornerstone of MPT is the idea that volatility, measured by standard deviation, is synonymous with risk. While this concept has profoundly influenced financial thinking and decision-making, it's not without its critics. In particular, the assumption that volatility equates to risk has been challenged, especially when considering private debt investments with first lien positions on properties. This article explores why MPT's notion of volatility as risk is flawed and highlights the merits of private debt as a high-yield, lower-risk investment.

The Flaws in Equating Volatility with Risk

1. Short-term Market Fluctuations vs. Long-term Investment Goals: MPT's emphasis on volatility can lead investors to overly focus on short-term market fluctuations. However, true investment risk should be measured by the potential for permanent loss of capital, not temporary price swings. For long-term investors, short-term volatility is often irrelevant, as it does not impact the intrinsic value of the investment.
2. Behavioral Factors: Human behavior plays a significant role in investment decisions. Investors often react emotionally to volatility, leading to irrational decisions such as panic selling during market downturns. MPT's framework does not account for these behavioral factors, which can exacerbate perceived risk and lead to suboptimal investment outcomes.
3. Diversification's Limits: While diversification is a core tenet of MPT, it assumes that the correlations between asset classes remain constant. In reality, correlations can change, especially during market crises, reducing the effectiveness of diversification in mitigating risk. This limitation highlights the need for a more nuanced understanding of risk that goes beyond volatility.

1. Asset-Specific Risks: Not all assets behave the same way under market stress. Volatility-based risk assessments may overlook the unique risks associated with specific assets. For example, private debt, particularly with first lien positions on properties, may exhibit lower volatility but higher recovery rates in case of default compared to publicly traded equities.

The Case for Private Debt with First Lien Properties

Private debt has gained traction as an attractive investment option, offering high yields without commensurately higher risk. When private debt is secured by a first lien on properties, it provides additional layers of security for investors.

1. Priority of Claims: A first lien position ensures that the lender has the highest priority claim on the collateral in case of borrower default. This priority significantly enhances the likelihood of full recovery of the investment, reducing the true risk compared to unsecured or subordinated debt.
2. Collateralization: Private debt secured by real estate provides a tangible asset that can be liquidated to cover losses. The value of the underlying property serves as a buffer against potential defaults, offering a level of security not available in other high-yield investments like high-yield bonds or equities.
3. Stable Cash Flows: Private debt investments typically generate regular interest payments, providing a steady stream of income. This stability is particularly valuable in volatile market environments, offering predictability and reducing the overall investment risk.
4. Risk-Adjusted Returns: Private debt with first lien properties often delivers higher risk-adjusted returns compared to traditional fixed-income investments. The combination of high yields and lower default rates makes it an attractive option for investors seeking to enhance their income without taking on excessive risk.
5. Market Dynamics: The private debt market is less susceptible to the same level of speculative trading and price manipulation that can drive volatility in public markets. This relative stability further supports the case that private debt is a lower-risk investment despite offering high yields.

Real-World Examples

Consider the aftermath of the 2008 financial crisis. While traditional investments like equities and corporate bonds experienced significant volatility and losses, private debt, particularly those secured by real estate, demonstrated resilience. Lenders with first lien positions on properties were able to recover their investments through foreclosure and sale of the collateral, underscoring the lower risk profile of these assets.

Conclusion

While Modern Portfolio Theory has provided valuable insights into investment strategies, its equation of volatility with risk has limitations. Volatility, as measured by short-term price fluctuations, does not fully capture the true risks faced by investors, particularly in the context of long-term investment horizons and asset-specific considerations. Private debt with first lien positions on properties offers a compelling alternative, providing high yields with lower risk through collateralization, priority of claims, and stable cash flows. As investors seek to navigate an increasingly complex financial landscape, re-examining the assumptions underlying MPT and exploring the benefits of private debt can lead to more informed and effective investment decisions.

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Dan Dobry

Vice President PWFO