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For our new direct lending strategy, skilful origination is key

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.

Our proposition
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.

Market outlook
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.

This document has been prepared using information which is confidential and proprietary to The Royal Bank of Scotland plc (“RBS”, “we”, “us” and “our”). This document and any dispute arising under or in connection therewith is to be governed by and construed in accordance with English law.

This document is being issued to you (the “Recipient” or “you” or “your”) by Hermes Investment Management Limited (“Hermes”) solely in connection with your potential investment in a direct lending fund being established by Hermes (the “Specified Purpose”).

RBS and Hermes (the “Institutions”) are separate institutions each acting on their own behalf and not as agent or for the benefit of any other person. Nothing in this material is intended to, or shall be deemed to: (i) establish or represent any partnership or joint venture between the Institutions; (ii) constitute any Institution as the agent of the other Institution; or (iii) constitute any Institution making or entering into any representation, commitment or assurance of any kind for or on behalf of any other Institution.

Any information in this document which relates to or refers to RBS and/or its Financial Sponsors business (“RBS Confidential Information”) is confidential and must not be disclosed in a manner inconsistent with the Specified Purpose. Where you have entered into a confidentiality agreement with Hermes in respect of this document and/or the RBS Confidential Information you must comply at all times with the terms of any such confidentiality agreement(s) and the use restrictions therein.

This document does not constitute an offer or invitation by RBS in respect of the Specified Purpose or any financing or any other sale or purchase of securities. The RBS Confidential Information is not intended for distribution to, or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation and must not be reproduced or disclosed (in whole or in part) to any other person without our prior written consent.

The RBS Confidential Information is not and does not purport to be comprehensive and we have no obligation to update it. Any information in this document provided by RBS has not been verified independently. The RBS Confidential Information is provided on a strictly non-reliance basis and should not be relied upon as the basis for an investment decision. In compiling the RBS Confidential Information we have relied upon and assumed, without verification, the accuracy and completeness of all information available to us. No representation or warranty, express or implied, is or will be made and no responsibility or liability is or will be accepted by RBS or any of its affiliates or by any of its respective officers, employees or agents in relation to the accuracy or completeness of any part of this document or any other written or oral information made available to you, your affiliates, connected companies, employees or advisers (and any such liability is expressly disclaimed). In particular, but without prejudice to the generality of the foregoing, no representation or warranty is given as to the achievement or reasonableness of any returns, projections, estimates, valuations or prospects contained in any part of this document or in such other written or oral information.

The Recipient acknowledges and agrees that no person has, nor is held out as having any authority to give any statement, warranty, representation, or undertaking on behalf of RBS in respect of the RBS Confidential Information. We give no undertaking to provide the Recipient with access to any additional information, to determine the accuracy or reasonableness of information or assumptions, to update this document or any additional information, or to correct any inaccuracies in it which may become apparent. Any views expressed in this document in respect of RBS Confidential Information (including statements or forecasts) constitute the judgment of RBS as of the date given and are subject to change at any time without notice.

You are solely responsible for compliance with law and regulations which may apply to this document and the Specified Purpose in jurisdictions applicable to you and your affiliates. This document does not constitute an offer to sell or an invitation to purchase securities in any jurisdiction. The RBS Confidential Information is not to be construed as legal, tax, regulatory, accounting, investment or business advice, and is not intended to form the basis of any investment decision. You should consult your own advisers on such matters as you deem appropriate.

This document is provided to you on the basis that you understand that RBS is not providing you with any "investment advice" within the meaning of Article 53 of the FSMA 2000 (Regulated Activities) Order 2001 and as a result, RBS is under no obligation to assess the suitability of the information provided in light of your knowledge and experience, financial situation and/or investment objectives. A consequence of the above is that RBS will not provide you with advice on the merits of buying, selling, subscribing for or underwriting (or exercising rights to acquire, dispose of or underwrite) any particular investment instrument. As such, you acknowledge that you are capable of interpreting the information provided in this document and using that information to take decisions as regards the merits of investing in particular investment instruments.

By accepting this document, you agree to be bound by the foregoing limitations.

The Royal Bank of Scotland plc. Registered in Scotland No 90312. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB. Authorised by the Prudential Regulation Authority (the “PRA”) and regulated by the Financial Conduct Authority ( the “FCA”) and the PRA. National Westminster Bank Plc.  Registered in England and Wales No 929027.  Registered Office: 135 Bishopsgate, London EC4M 3UR.  Authorised by the PRA and regulated by the FCA and PRA.  The Royal Bank of Scotland plc is authorised to act as agent for National Westminster Bank Plc.

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