Industry Voice: How senior is your debt? Uncovering hidden risk and opportunity in direct lending

clock • 4 min read
Industry Voice: How senior is your debt? Uncovering hidden risk and opportunity in direct lending

Within private credit, direct lending offers a wide range of options for investors seeking the right balance of risk and reward for their particular needs. Understanding incremental risk factors is vital to ensure your investments align with your intended approach.

 

In a recently published report, we proposed a framework for analysing risk-adjusted returns for different direct lending strategies within private credit. We also discussed current market pricing and analysed whether investors are being fairly compensated for incremental loss factors such as leverage, subordination, and covenant light documentation. We began the discussion by looking at developments in the types of strategies widely acknowledged to make up direct lending as a subset of private credit.

Comparing risk-adjusted returns

In order to create this framework, we collected observable market pricing for both unitranche and traditional senior secured loans. We then modelled a typical enforcement scenario, where variability in credit quality is explained solely by the capital structure.

It is important to note that this analysis is not intended to show (indicatively or otherwise) expected returns for a given strategy. Rather, the intention is to create a means of benchmarking the relative performance of each strategy as a function of expected yield and default risk.

Conclusion

It should be noted that this analysis is intended as a framework for comparing direct lending strategies on a relative basis and not as an estimation of expected returns, indicative or otherwise. However, the results highlight clear differences that exist between unitranche and traditional senior secured loans, and demonstrates how unitranche strategies targeting a high gross yield often mask a variety of incremental risk factors that can result in sub-optimal risk allocation.

The right strategy will depend on investment priorities and many investors will continue to be persuaded by unitranche's attractive yield. However, for a significant portion of institutional investors, predictability of income and protection against losses is a primary concern. For these investors, the current range of unitranche funds is likely to be too riskseeking and/or incompatible with their liability-matching approach.

For investors whose direct lending replaces part of their liquid credit allocation, rather than being an alternative to private equity allocations or growth, a steady low-risk profile with a fair premium over liquid bonds is a commonly used option.

Meanwhile, the utilisation of leverage at the fund level remains an attractive option for investors seeking to enhance their gross yield from traditional senior secured strategies while maintaining a conservative investment approach, which is consistent with capital preservation and optimal risk-adjusted returns.

 

 

This article was funded by Federated Hermes

 

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. Any investments overseas may be affected by currency exchange rates. Past performance is not a reliable indicator of future results and targets are not guaranteed. This portfolio contains illiquid assets. Due to the nature of these assets, being typically private, unique and bespoke, these portfolio investments will not be as easily sold in the market as publicly traded securities. Ability to redeem from this investment is limited and may be significantly deferred, or impossible.

For professional investors only. This is a marketing communication. This document does not constitute a solicitation or offer to any person to buy or sell any related securities, financial instruments or products; nor does it constitute an offer to purchase securities to any person in the United States or to any US Person as such term is defined under the US Securities Exchange Act of 1933. It pays no regard to an individual's investment objectives or financial needs of any recipient. No action should be taken or omitted to be taken based on this document. Tax treatment depends on personal circumstances and may change. This document is not advice on legal, taxation or investment matters so investors must rely on their own examination of such matters or seek advice. Before making any investment (new or continuous), please consult a professional and/or investment adviser as to its suitability. All figures, unless otherwise indicated, are sourced from Federated Hermes. All performance includes reinvestment of dividends and other earnings. Further information on the Fund is available in the Information Memorandum.

Issued and approved by Hermes Fund Managers Ireland Limited ("HFMIL") which is authorised and regulated by the Central Bank of Ireland. Registered address: The Wilde, 53 Merrion Square, Dublin 2, Ireland. HFMIL appoints Hermes Investment Management Limited ("HIML") to undertake distribution activities in respect of the fund in certain jurisdictions. Hermes Investment Management Limited is authorised and regulated by the Financial Conduct Authority. Registered address: Sixth Floor, 150 Cheapside, London EC2V 6ET. Telephone calls may be recorded for training and monitoring purposes. Potential investors in the United Kingdom are advised that compensation may not be available under the United Kingdom Financial Services Compensation Scheme.

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