What is direct lending? How did you position your strategy? These are just a couple of the most commonly-asked questions about direct lending by our clients and prospective clients.
Earlier this month, we sat down with the Hermes Direct Lending team as they tackled the most pressing questions about the asset class.
Simply put, direct lending is the term commonly used to describe when institutional investors – including asset managers, pension funds, insurers or sovereign wealth funds – lend directly to corporates without the use of bank intermediation.
There are three core direct lending strategies that investors can access – senior secured loans (the traditional bank loan, which sits at the top of the capital structure); mezzanine loans (typically sits at the bottom of the capital structure, behind senior loans and ahead of equity); and unitranche loans (the most common strategy in direct lending – a single loan that combines a senior secured loan and a mezzanine loan into one loan facility).
Currently, investor demand is being driven by the search for yield in a low-rate environment. But direct lending offers many other attributes that make it attractive to investors – and they explain why fundraising has been so successful in Europe for this relatively nascent asset class:
- High potential risk-adjusted returns: Direct lending will usually provide compensation of around 4-6% above Libor/Euribor for senior secured loans – and that generally increases to returns exceeding Libor/Euribor plus 9%-12% for lower ranking loans. This is especially attractive when you consider recovery rates of these types of loans in a default scenario compared with other fixed income asset classes.
- Illiquidity premium: SME loans will usually provide investors with an illiquidity premium over syndicated loans and high-yield bonds. However, the size of the illiquidity premium will fluctuate depending on the risk of the underlying illiquid loan.
- Floating rate yield: European loans earn a floating rate yield and therefore provide investors with a form of hedging against inflation. Also, most loans will have a Libor or Euribor floor attached to them, protecting investors against negative interest rates.
- Low volatility: Volatility in the direct lending sector has been low compared to traditional capital markets, generating stable returns throughout market cycles relative to equity indices.
Over the past two years, the direct lending market has become increasingly competitive. With fund raising of alternative lenders at an all-time high and banks in most western European jurisdictions returning to the SME loan market, competition for deployment has intensified. This is especially true of alternative lenders – who are competing to source the best loans.
There are still plenty of loans on offer for senior secured lenders with lower return targets, but unitranche lenders – who target higher yields – have been increasingly forced to compete on loan terms rather than price to deploy their funds. This means many unitranche lenders have accepted diluted lender protections and aggressive financial structures in return for higher yields. In turn, this has led to very aggressive lending practices in the SME loan market.
Across different strategies, yields have behaved differently: senior secured loans have benefited from stable return yields (banks control this market and they will not accept significantly lower loan pricing due to their cost of capital); mezzanine loans have generated relatively stable yields (they are uncommon in the European market); and in the unitranche segment, yield compression has been most acute (alternative lenders have to compete against a cheaper offering from senior secured loans). Since 2012, unitranche pricing has fallen from yields of 9%-10% to 7%. And, as they still have to meet their return targets, we are unlikely to see further yield compression. However, future competition will be centred on weakening loan terms.
We see the most value in the senior secured segment. That’s because stable risk-adjusted yields on offer are stable and stronger lender protection rights mean that recoveries are high in a downside scenario. What’s more, it’s important to understand a direct lender’s origination strategy because a lender that cannot source the best loans will underperform those with a strong origination strategy.
There is no doubt that loan terms have deteriorated in the European mid-market in recent years. This has been primarily driven by new entrants to the space – and their return targets. Historically, the European mid-market was bank-led and loans generated yields of about 5%-6.5%. The pull-back by banks in the post-financial crisis era prompted alternative lenders to fill the void.
But as banks have returned to the lending market and the number of active direct lending funds has exploded, competition has intensified. Due to the timing of when funds launched, certain strategies, such as unitranche, have higher return targets than current market yields. Consequently, they have been forced to compete on loan terms rather than price. Prior to 2008, loans were accompanied by a full covenant package – that is, four covenants with headroom levels – the point at which the borrower’s earnings would have to degrade to trigger a default – set at 25%-30%. Today, it’s common to see unitranche funds offer only one covenant with headroom of more than 40% (in this instance, lenders can tell investors that they avoid covenant light loans; but with such meaningless headroom, they effectively do not) or no covenant at all.
In addition, EBITDA numbers – used in the loan documentation to calculate covenant numbers – have also been eroded, with EBITDA add-backs inflating a borrower’s earnings and allowing them to take on more debt than appropriate.
Against a robust economic backdrop (where borrowers are thriving), weaker lending protections are unlikely to be too much of a problem. But, when conditions start to deteriorate and borrowers begin to underperform, the net returns (after losses) of direct lenders with weak loan protections will start to suffer.
Our two direct lending funds – Hermes UK Direct Lending and Hermes European Direct Lending – seek capital preservation and yield capture. We are not willing to provide loans where terms or pricing fail to meet our threshold. And our strong origination strategy places us in a superior position to most other funds: we established co-lending agreements with four top-tier banks in northern Europe. These agreements mean that our four partner banks are legally obliged to show us all loan opportunities that they originate in their regions, within agreed parameters. This gives us access to a significant pipeline of about 500 deals per year, allowing us to select the best deals (15-20 p.a.) to invest in on behalf of investors.
We have positioned our two direct lending funds – Hermes UK Direct Lending and Hermes European Direct Lending – to provide investors with access to stable, low-correlated returns, while minimising downside risk. We aim to achieve this by:
- Accessing the best deals to invest in on behalf of our investors through our legally-binding origination agreements with four banks in northern Europe. Through these exclusive partnerships, we see about 500 loans each year (our strategy invests in about 15-20 p.a.);
- Lending to the best geographies, notably the most creditor-friendly jurisdictions and mature lending environments to ensure fast, professional restructurings and maximum recoveries can be achieved, if necessary, thereby preserving yield for investors; and
- Analysis of potential investments by an experienced team, with an average of 15 years’ experience, that have invested in loans throughout the full extent of credit cycles.
We have negotiated legally-binding origination agreements with four leading European banks in the mid-market lending space, covering the UK (NatWest), Benelux (KBC), Germany (DZ) and Scandinavia (Danske). Under these agreements, our partner banks are legally obliged to show us all loan opportunities that they see in their regions within agreed parameters. This provides us with a rich pipeline of senior secured mid-market loans in northern Europe – placing us in a superior position to most other funds as it allows us to be incredibly selective about which loans we choose to invest in. To put this in perspective, these agreements grant us access to about 500 loans each year, while our investment strategy invests in about 20 loans over the same period. What’s more, we are under no obligation to act on these opportunities.
If we progress with an opportunity, we undertake independent analysis and are part of the structuring discussions around the terms and economics of the loan. Subject to obtaining credit approval from our Investment Committee, we will lend on the same economic and legal terms as the originating bank, as well as being a lender of record. Once the loan is made, we independently manage the loan, with no input from the originating bank.
We focus on companies in the lower SME segment that generate €5m-€35m of EBITDA each year. Loans to these types of companies are illiquid and so, they provide an illiquidity premium. In addition, these loans have strong lending protections, which is very important in a downside scenario. This explains why mid-market loans benefit from stronger recoveries in a downside scenario than syndicated loans (which tend to have looser terms). While the market is currently in an aggressive phase, loans to mid-market companies tend to have a more conservative profile than syndicated loans to large-cap companies, where competition has been more aggressive.
We lend to both sponsor- and non-sponsor-owned companies. This allows us to focus on providing loans to companies which offer the most value from a risk-adjusted basis for our investors.
We also tend to shy away from cyclical companies. Instead, we focus on companies that benefit from stable cashflows and profitability through-the-cycle; a strong asset base; high barriers to entry; a first-class management team and a tier one sponsor. As we avoid cyclical industries, it is unlikely that we would lend to retail companies or those that are dependent on consumer spending. We also avoid lending to companies that trigger adverse ratings in terms of environmental, social and governance (ESG) considerations. In general, the industries we focus on include healthcare, education, business services, financial services and IT.
We typically invest in a Term Loan B in a senior debt structure – normally the highest priced senior loan due to its bullet repayment and tenor of seven years (a Term Loan A is normally a six-year amortising loan, and is typically preferred by bank lenders).
The interest rate paid on a Term Loan B is usually at least 50bps higher than a Term Loan A. The legal maturity of a Term Loan B is seven years, but it typically has an average life of 3-4 years.
Loans are floating rate instruments, priced over Libor/Euribor. This means that the yield increases as rates increase. Conversely, the loans typically have a Libor/ Euribor floor, protecting lenders in a negative-rate environment. We also receive upfront fees on all of our loans, which vary depending on geography, but are likely to be in a range of 2.5% to 3.0%.
As a senior lender, we benefit from a full security package, including share pledges and pledges over fixed and floating assets.
Our loans include covenant protections, which are quarterly financial tests that the borrower must meet. The headroom at which these tests are set is meaningful. This means that when a company begins to underperform and a breach occurs, lenders can impose a default on the company and take appropriate action to protect our investment. In essence, we do not expose our investors to the risks presented by cov-loose (headroom greater than 40%) or cov-lite (loans with no covenants at all) deals.
Our ESG overlay refers to how we incorporate ESG analysis into our investment process. We believe that lending to companies with good ESG practices reduces overall investment risk, improves long-term returns and supports our aim of preserving capital while capturing yield.
We adopt a three-pillar approach to ESG in direct lending:
- Exclusions: we are prohibited from lending to certain industries as the risks outweigh the rewards for investors. They include gambling, tobacco, distilled alcohol, pornography, weapons and munitions, fur trade and animal-tested products, genetically-modified organisms, destructive fishery practices and businesses damaging primary or tropical habitats. In addition, other industries (such as energy, chemicals and manufacturing) are subject to enhanced due diligence. That way, we ensure that we are comfortable with all current and potential ESG risks.
- Awareness: we analyse each investment opportunity across the E, S and G components. Consequently, we award each component a low-, medium- or high-risk rating. The weakest rating of the three components represents the overall score for the loan. If any component is rated high-risk, we automatically reject the loan opportunity. Once a loan is made, we monitor the ESG ratings regularly.
- Engagement: should an issue arise during the life of a loan, we will seek to actively engage with the sponsor and the management team of the borrower to remedy or improve any ESG issues. We also collaborate with our in-house engagement specialists, Hermes EOS, during the consultation process. Indeed, improving ESG risks has been shown to increase the enterprise value of a company, which in turn makes our investors more secure and benefits the shareholders of the company as well as society.
Unitranche loans are hybrid structures (senior and junior debt) stretching further down the capital structure than senior-only structures. Therefore, the higher yields reflect the higher blended risk of the resulting larger combined debt quantums. More importantly, as a unitrache loan will go deeper into the capital structure, there is less equity to protect the loan. At a time when enterprise values are at an all-time high, there is a risk that some unitranche loans will not be covered by the equity in the company should enterprise values revert to more normalised levels.
Unitranche loans can be provided by a single lender or through several parties that enter into a first-out/second-out agreement among lenders (AAL). For AALs, it remains to be proven whether creditors comprise a single class for the purpose of the English law scheme of the arrangement, which can result in difficulties and protracted restructurings. Given their nature, unitranche loans come at higher ticket sizes and thereby imply higher concentration risk towards a single borrower in a direct lending portfolio.
Europe’s leveraged loan market is very established and offers substantial diversification potential, benefitting from a range of geographies, currencies, economies (at different stages of the economic cycle) and innovation. Conversely, the US relies on a single economic area.
European leveraged loans tend to be more conservative. For instance, equity contributions are generally higher (e.g. it was 47.8% in Europe vs. 40.5% in US in 2018, according to S&P’s LCD), leaving PE-sponsors with more skin in the game, while lenders have comparatively more cushion in a downside scenario. Furthermore, European buy-out deals tend to be financed at lower leverage levels (5.0x in Europe vs. a US average of 5.6x over the last five years, according to LCD), while purchase price multiples are typically higher in the US (9.8x in Europe vs. an average of 10.2x in the US over the last five years; 9.5x in Europe vs 10.3x in US so far this year, according to LCD), potentially overvaluing assets driven by competitive pressure. Spreads – that is, margin over base rates – are typically higher in Europe, while legal terms tend to be more aggressive across the Atlantic as evidenced from the dominance of covenant-lite loans.
In addition, the European loan market has a number of structural differences compared to the US market:
- Exposure to extractive industries, which are highly cyclical, is limited in Europe (in the US, the vast number of shale businesses mean many borrow from alternative lenders);
- Less volatile than US loans because there are no retail investors in Europe;
- The European loan market continues to be a bank relationship-driven market in Europe. That means banks control the majority of loans, which can make it difficult for direct lenders to access high-quality loans. But through strong origination networks – particularly those featuring formal co-lending agreements with European banks – investors can consistently access high-quality loans on an exclusive basis (as already discussed, we have four legally-binding co-lending agreements).
- Europe appears to be more advanced when it comes to incorporating ESG into investment processes and boasts a stronger sustainability and stewardship focus than its US counterparts.
- The views and opinions contained herein are those of Hermes Direct Lending, and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.
- This commentary is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments.