Origination: key to success in direct lending

The foundation of a strong direct-lending portfolio is skilful origination. It provides access to high-quality loans in an increasingly competitive market, which can improve prospective returns and help reduce the risk of being exposed to companies that default.

In the direct lending market, having access to the best deals to invest in on behalf of investors is possible through co-lending agreements. The Hermes Direct Lending Strategy has an exclusive co-lending partnership with a leading UK lender to small- and medium-sized enterprises. Under this agreement, the bank is legally bound to invite us to participate in all new loans on equal economic terms, while we independently conduct credit analysis and due diligence and retain discretion over any deal we commit to. The ability to choose the right loans prevents the team from becoming a forced lender - that is, one who is obliged to invest in a limited number of opportunities. In essence, having a co-lending agreement with a bank enables us to be credit 'pickers' rather than credit 'takers'.

The benefit of experience

An experienced team will also be able to access compelling loan opportunities through solid contacts within private-equity houses, debt advisors, legal and accountancy firms and corporate treasurers. The team's contact base and co-lending agreement forge a strong and unique origination strategy, which provides a rich pipeline of high-quality loans, and thereby a portfolio with the potential to achieve stable, attractive returns.

Credit-focused analysis

A direct lending strategy also requires a detailed analysis of any opportunity that presents itself. This can be done by undertaking a full financial and business analysis to assess the risk of a credit event involving the borrower, such as its sensitivity to the business cycle, level of competition sector-wide and pertinent regulatory issues. It is also vital to understand the company's business model, the resilience of this model and its financial profile. Further considerations include the borrower's ownership structure and management team, as both constituents will be paramount to the success of a business. By lending to selected businesses, we aim to preserve capital and capture yield for our investors.

In a low-yield environment, direct lending offers access to an attractive source of alternative yield. While there are inherent risks associated with direct lending, a strategy driven by a skilled team with a strong origination capability can mitigate these threats while capturing opportunities. In this way, the Hermes Direct Lending Strategy aims to consistently provide long-term outperformance for investors.

For further information, please visit the Hermes website: https://www.hermes-investment.com/ukw/capabilities/private-markets/direct-lending/ 

Patrick Marshall, head of Private Debt and CLOs

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