Concentration risk refers to how much money a fund manager will risk on any one client. For example, a fund’s rules might say that no more than $10million may be lent to any one borrower.
When thinking about a loan approval, it’s important to understand how the person managing the capital thinks. A key concept is the fact that a fund manager has to accept that, despite their best efforts, a small amount of their loans will go sour sooner or later – often through no fault of the client’s. This means that it really matters how much money they invest in any one client so that they limit how much money they can lose when the unexpected happens. They also know that there is very little chance of all their loans going sour at the same time. They can take comfort that the remaining loans will make up for the one that went bad.
Concentration limits are directly proportionate to the size of the fund. Larger funds (often based in London or New York) tend to have higher concentration risk limits because, say, $10million makes up a relatively small percentage of their fund size. A fund based in South Africa or Mauritius will tend to have smaller limits where $1million is a significant amount of risk to take with a single client.
Concentration risk is usually a hard limit that a fund manager has little discretion over, for good reason. So make sure you understand the limits so that your loan size can fit into the most desirable range for the fund.