Laura Vaughan: I am Head of Direct Lending at Federated Hermes, an $800 billion AUM global active asset manager.
My role sits within the Private Credit business, which launched in 2015 and lends across Direct Lending and Real Estate Debt strategies.
As a member of the Private Credit Investment Committee, I am responsible for implementing the overall strategy of our Direct Lending funds, alongside playing a key role in fundraising, as well as managing a team of investment analysts who assess potential loans made by our funds.
Laura: The Private Credit market has grown rapidly over the last decade, as following the global financial crisis, when banks retrenched from lending, they created a gap in the market.
Institutional investors have been – and will continue to be – drawn to Private Credit for a number of reasons. It has the potential to offer low volatility, because it's not a marked market. It is valued quarterly, but based on bespoke valuation policies, which means, as markets spike and trough, the direct lending loans aren't impacted by the swings, so it provides stability in an overall portfolio.
Importantly, quarterly cash income offers an attractive element for investors, such as insurance companies that are seeking liability-matching income portfolios. Also, an allocation to a low-risk Direct Lending strategy can come from either their Fixed Income bucket to provide a counterweight to a more volatile or higher-risk bond portfolio or from their alternatives bucket to offer a counterweight against a full unitranche or private equity strategy.
"The attractiveness of the asset class is that it
addresses investor requirements."
Direct lending investments also act as a partial inflation hedge because they're floating rate instruments – so as rates go up, you benefit from the underlying floating base rate as well. Investors find that useful in a changing interest rate environment.
The attractiveness of the asset class from multiple points of view – from portfolio construction through to yields to quarterly cash flows – is that it addresses various investor requirements. The underlying diversification in the portfolios, whether geographic, end-sector, or currency, can also be designed to meet investor needs.
Laura: As the macroeconomic backdrop shifts and interest rates fall, direct lending is coming of age. For many years, the asset class has enjoyed low default rates, and recoveries have been solid. The recent adverse changes in market conditions have, however, increased the pressure on some borrowers. Our direct lending strategy prioritises deal quality; our ability to source high-quality deals that are unavailable elsewhere helps ensure long-term performance and gives the strategy an edge in varied conditions.
Our Direct Lending business focuses on direct, senior secured lending to small and mid-sized businesses in Northern Europe, targeting income above levels provided by comparable fixed income assets.
Out of three main categories of underlying debt – mezzanine, unitranche and senior secured – we believe the latter offers investors the best risk-reward profile at the present time as it sits at the top of the capital structure, which means that in the event of a default, these lenders are the first to be repaid through proceeds from the sale of the business.
"In northern Europe, investors are lending into one of the most creditor-
friendly jurisdictions, as opposed to pan-European or the US."
On top of a compelling return, we believe the northern European lower mid-market senior secured segment offers less downside risk and provides one of the best legal environments to negotiate any restructurings. In the lower mid-market, significant improvements can be seen in lender protections in loan documentation. Lenders also have greater negotiating power in terms of loan documentation, creating space to negotiate the inclusion of ESG-linked clauses.
In northern Europe, investors are lending into one of the most creditor-friendly jurisdictions, as opposed to pan-European or the US. These are geographies where lenders have tried and tested the legal systems regarding insolvencies and can expect to undertake restructurings in under a year, thereby maximising recoveries relative to other jurisdictions.
Laura: In an increasingly competitive Private Credit landscape, deal origination is critical to achieving consistent net returns across the asset class because there are only a finite number of transactions that come to market. We see deal sourcing as a powerful tool for managing risk and sustaining returns, particularly in challenging economic times.
Our origination approach is built around a series of four bank partnerships that afford us access to some of the most attractive deals in our preferred segment. These partnerships are with lower middle market banks in our targeted geographies.
The relationships are governed by legally binding evergreen agreements in which our bank partners are obliged to introduce us to all transactions they originate that sit within agreed parameters. Then, if we want to do the transaction, we submit a joint term sheet with the banks, which means we're going in with a larger hold, and that means we are becoming more relevant and have a larger negotiating power in the transaction.
Our strategy benefits from this right of first refusal with our bank partners, ensuring we are always sourcing potential loans, rather than seeing transactions turned down by other lenders ahead of us.
We are seeing more partnerships in the market between funds and banks. However, none of these appear to be legally binding, reducing the likelihood of that right of first refusal or exclusivity.
"We are seeing established direct lending funds have a significant
advantage over market entrants or less experienced fund managers."
A fund manager with a weak origination strategy – and therefore an unpredictable deal pipeline – may find itself forced into certain lending scenarios; accepting weak loan terms or lending to borrowers that have previously been refused by the market, in order to deploy capital.
We are also seeing that established direct lending funds – with a track record and reputation for speed and reliability of execution – have a significant advantage over recent market entrants or less experienced fund managers.
Borrowers and sponsors want a lender that not only has the certainty of execution, i.e., they've been operating in the market for X number of years and have shown that they're always there on the day with the proceeds to fund the transaction, but also private equity will cast a keen eye to see how that direct lender behaved, for example during Covid-19 and during the rising rate environment/higher inflation environment. Were they supportive of borrowers? Were they rushing to push for tweaks and pushing unnecessary pressures on the borrower when things got a bit difficult?
They want to find someone who will be collaborative and supportive when the situation warrants that. If you can't prove that, or you're relatively new, private equity will look at two people offering the same product and will go for the one where there's a track record of behaviour.
Laura: We were early adopters of ESG integration within the private credit space and have undertaken proactive work to educate investors, implementing and evolving an ESG overlay for Federated Hermes’ direct lending funds, which are classified as Article 8 under the Sustainable Finance Disclosure Regulation (SFDR). We have tools, including our carbon calculator and ESG risk weighting system to form an analysis of ESG risk on all borrowers.
"When we structure loans, we are seeking to identify potential ESG-related
risks that could impact the future cash flows of the borrower."
The team undertakes credit analysis to assess the creditworthiness and ESG profile of any potential investment. We exclude certain sectors and also have sectors where we will be required to do enhanced due diligence, such as manufacturing or certain energies.
When we structure loans, we are seeking to identify potential ESG-related risks that could impact the future cash flows of the borrower. That means we do a deep dive and link in with management and the sponsor. Interestingly, more and more today, we're receiving ESG due diligence reports, which are being driven by the private equity industry as well, which is helpful.
Also, as these are illiquid loans, which means that if an ESG issue arises once we've made a loan, it can be challenging. However, we have one of the world’s largest stewardship and engagement teams, so we can use their knowledge on the public-market side to discuss solutions and potential mitigations.
This means that rather than just raising an issue, we can come up with a potential solution. You want to reduce as many risks as possible and enhance the enterprise value, which is what we're secured on. It also means private equity is supportive because you're reducing a risk in the business that they've bought.
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To learn more about private credit at Federated Hermes, visit: Private Credit | Federated Hermes Limited (hermes-investment.com)
The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other communications. This does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
Issued and approved by Hermes Investment Management Limited (“HIML”) which is authorised and regulated by the Financial Conduct Authority. Registered address: Sixth Floor, 150 Cheapside, London EC2V 6ET. HIML is a registered investment adviser with the United States Securities and Exchange Commission (“SEC”). Distributed in the EU by Hermes Fund Managers Ireland Limited which is authorised and regulated by the Central Bank of Ireland. Registered address: 7/8 Upper Mount Street, Dublin 2, Ireland, DO2 FT59.
