Authors

We are joined by the Hermes Direct Lending team for our quarterly Q&A series.

Hermes Investment Management, the £36 billion manager, has announced the expansion of its global fixed income team, with the appointment of Carina Spitzkopf as a Director for Private Debt.

Despite ongoing disintermediation in the European direct-lending market, strong origination agreements with banks continue to be vital to access high-quality loans – particularly in the mid-market space. In this podcast Patrick Marshall, Head of Private Debt and CLOs and Laura Vaughan, Head of Direct Lending explain why.

In an era of rising correlations, institutional investors are increasing exposure to alternative asset classes. At the forefront of this trend is direct lending, where institutional investors can access sustainable yields and sources of uncorrelated returns. In his latest insight, Patrick Marshall, Head of Private Debt and CLOs at Hermes Investment Management, discusses how to successfully tap expanding opportunities in European direct lending.

Hermes Investment Management (Hermes), the £33.0 billion manager, has today announced that it has launched the Hermes European Direct Lending Fund, which is managed by Patrick Marshall, Head of Private Debt & CLOs. The European Fund follows the successful launch of the UK Direct Lending Fund in 2016. The Fund offers access to the stable, low-correlated returns from high-quality, senior-secured loans to a diverse range of middle-market businesses in the UK and Europe, with a focus on Scandinavia, Germany, Benelux and Ireland. Senior-secured transactions are originated through co-lending partnerships with Danske Bank, DZ Bank and KBC Bank, which sit alongside the existing UK mid-market agreement in place with Royal Bank of Scotland. As some of the largest mid-market lenders in their respective regions, the agreements provide investors access to a strong deal flow, with attractive opportunities across a wide range of sectors. Further to this, the team’s broad network of contacts among private equity firms, banks and borrowing businesses creates an additional source of origination across Europe.

Mark Miller, Head of Institutional meets with Patrick Marshall, Head of Private Debt and CLOs to discuss the Hermes European Direct Lending Strategy.

Mark Miller, Head of Institutional meets with Patrick Marshall, Head of Private Debt and CLOs to discuss the Hermes European Direct Lending Strateg

Not all senior loans are created equal, and the cov-lite form – those with weaker investor protections – are dominating the large-cap segment of the European market. We completely avoid these instruments, focusing instead on covenanted mid-market deals, which offer more attractive returns with stricter risk controls than cov-lite large-cap deals.

Direct lending is a promising market in Europe, but does it offer better opportunities than its more-established US counterpart? Patrick Marshall, Head of Private Debt & CLOs at Hermes Investment Management, assess the differences between the two and presents his views on what it takes to invest successfully in European loans. Europe: New kid on the bloc Europe’s emergence as a direct lending market is still relatively recent. The changing regulatory landscape in the post-financial crisis era transformed loan markets. New capital adequacy rules, amplified by the Capital Requirements IV directive under Basel III, have forced banks to reduce risk and therefore the size of their loan books. Prior to 2008, banks provided more than 80% of larger corporate loans in Europe. Data from S&P LCD shows the European loan market grew aggressively from €15bn in 1998 to €165bn in 2007, a year before the global financial crisis. In its wake, small- and medium-sized (SME) businesses had little access to capital. Their borrowing needs could not reach the scale required to cost-efficiently access the bond market. This created a gap in the market for alternative lending, and investment firms have filled the void left by European banks to provide SME financing. Direct lending now accounts for 10% of Europe’s loan market[2]. This rapid growth is in no small part driven by a surge of interest in the asset class. Investors with long-term liabilities are attracted by an illiquidity premium of almost 60bps, as well as a desire for strong yields that are lowly correlated with listed markets, capital preservation and inflation protection.

Since the financial crisis, changing regulation and a more conservative risk environment mean that banks have been reluctant to make loans of the size that they did prior to the crash in 2008. As a result, small and medium-sized companies have had to look to other financing providers. One, albeit small, source of funding has been institutional investors, which have established pure direct lending funds to service this growing demand. Patrick Marshall, Head of Private Debt & CLOs at Hermes Investment Management, discusses the options for loan origination. Like all asset classes, this asset class comes with inherent risks. These include credit risk in the form of borrowers’ defaults, which was a significant issue for lenders during the financial crisis. Medium-sized companies have an average default rate of around 3.1% over the past 10 years. However, senior secured loans, which stand at the top of the capital structure, enjoy average recoveries on default in Europe in excess of 75%, which is significantly higher than some other asset classes such as high yield bonds.