In developing the Hermes Direct Lending Strategy, we knew that the ability to consistently source high-quality loans is essential to generating the resilient returns with low volatility and correlations that can be derived from the asset class. Our unique origination strategy is designed to provide us with access to attractive deals.
In the Hermes Direct Lending Strategy, we offer a diversified portfolio of attractive first-lien UK and European senior loans. We aim to generate stable cash income and long-term returns of LIBOR plus 6% on a gross annualised basis. For investors seeking higher returns, a co-investment vehicle holding the same assets can be run in parallel to the Strategy to enable greater exposures to loans with more aggressive risk/return profiles.
Our investment team has a comprehensive range of credit skills, from loan origination to restructuring, which have been exercised through market cycles. In a competitive market, our ability to consistently source high-quality loans is a key strength. It is based on our unique origination strategy, which features a co-lending partnership with RBS for senior-secured loans to UK mid-market businesses, and our own ability to source deals, thereby generating a healthy pipeline of attractive senior-secured and unitranche loans.
We lend primarily to UK mid-market businesses but can hold a maximum exposure of 30% towards European companies. These enterprises typically have EBITDA ranging from £10m to £75m and enterprise values of £25m-£350m. The senior-secured loans we target have leverage below 5.5x, while unitranche loans are marginally more highly geared. Leverage is not used at the Strategy level.
Hermes and RBS: a focused co-lending partnership
Our formal co-lending agreement with RBS provides us with access to the bank’s book of robust senior-secured loans to UK mid-market businesses. This opportunity is an important part of our origination strategy, complementing the ability of our experienced team to source deals through market contacts in the UK and Europe. RBS has 120-140 borrowers on its £1.6bn loan book, and its 20-year track record proves that it has originated and managed loans through the peaks and troughs of market cycles. In 2014, the bank originated 223 transactions with mainly private equity-owned businesses across a broad range of industries, of which 58 high-quality loans were completed – an impressive success rate that helped make the group the third-largest mid-market lender in the UK in 2015.
Industry exposures of the RBS mid-market loan book, July 2015
Source: RBS Financial Sponsors. Chart shows drawn and undrawn commitments.
Importantly, Hermes and RBS share closely aligned credit risk appetites and are committed to agreed due diligence and execution processes, maximising our ability to capture opportunities quickly. The loans are originated by the RBS Financial Sponsors Group, which staffs 60 origination and transaction employees in seven locations across the UK, from London to Aberdeen. We perform our own credit analysis on each transaction, providing two layers of due diligence for investors, and exercise full discretion on which loans we participate in. We are under no obligation to lend in any transaction. Hermes is one of three co-lenders in the partnership, alongside M&G Investments and AIG, but is the only investor providing investors with exposure to RBS-originated loans through a single vehicle.
Independent origination skills
Through contacts including private equity sponsors, debt advisory groups, banks and corporate management teams, we originate senior-secured and unitranche loans in the UK and Europe. Each member of the team has through-the-cycle experience in these markets and skills that we consider to be essential: origination, structuring, execution, monitoring, restructuring and managing work-out situations. We perform intensive fundamental credit analysis on borrowers and transactions, seeking to preserve capital and maximise recoveries in downturns while capturing attractive yields. The co-lending agreement with RBS, plus the team’s own contacts, should ensure a flow of up to 200 primary-market loans each year.
Benefits of the asset class
Senior-secured mid-market loans have generated strong, stable returns in the past eight years with a 50bps per annum average excess return over larger, widely syndicated leveraged transactions. Occupying the top of the capital structure, they receive income and capital before all other instruments and have first claim on assets in the event of default. Floating-rate coupons, which track the movements of interest rates, should provide some inflation protection should UK monetary policy tighten in the coming years. Losses from the asset class are currently at historic lows, partly due to the high recovery rate of more than 70% at default due to their first-ranking security. The loans exhibit moderate to negative correlations with other asset classes, and their low mark-to-market volatility can help stabilise an investment portfolio.
Average European Term Loan B primary spread by deal size
Source: S&P Capital IQ as at September 2015. Chart shows performance of first-lien bullet term loans.
As banks continue to retreat from the corporate lending market in order to comply with capital adequacy regulations, alternative lending practices have evolved rapidly to supply small- and mid-market companies with debt for expansion or acquisitions. In the UK and northern Europe, the volume of M&A deals among mid-market businesses has increased substantially in recent years. Private equity firms, which own many of these businesses, have about £220bn in dry powder for leveraged acquisitions, creating opportunities for direct lenders.
In addition, there will be an estimated £33bn in leveraged buyout (LBO) refinancings from European collateralised loan obligations in the next two-to-three years. Lenders continue to benefit from high levels of equity cushion of about 40% in LBO transactions, and leverage multiples of 4.5x-5x, which are still below the pre-financial crisis peak of 6x. Ratios of EBITDA to cash interest are at their highest in the past decade.
Direct lenders in Europe also benefit from initiatives of national governments: the British Business Bank and UK Business Finance Partnership, the Novo Funds in France and a similar programme in Spain encourage alternative lending to small- and mid-market enterprises and provide significant support for the market.
The Hermes Direct Lending Strategy aims to generate stable cash income and long-term returns of LIBOR plus 6% on a gross annualised basis, and can offer higher bespoke return targets. Drawing on our experience and investment skills, we invest in high-quality senior-secured and unitranche loans to mid-market businesses in the UK and Europe. These are sourced through our unique origination strategy, which features a co-lending partnership with RBS for senior-secured loans to UK mid-market businesses, and our own ability to find deals, resulting in a healthy pipeline of attractive loans.
The views and opinions contained herein are those of the Hermes Specialist Fixed Income team and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products. The information herein is believed to be reliable but Hermes Fund Managers does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document 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. Figures, unless otherwise indicated, are sourced from Hermes. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions.
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Head of Private Debt and CLOs
Hermes Investment Management