Regulation Will Be The Primary Driver of Change

Regulation Will Be The Primary Driver of Change
Comments from Patrick Marshall, Head of Private Credit at Federated Hermes on the Private Credit market at the halfway point of 2024.

“A visit to Australia was high on my priority list in the first half of the year. With EY estimating that the market reached AUD$188bn in AUM at the end of 2023, up from AUD$175bn the previous year it has become a regional hub for Private Credit, and we believe, has huge potential and is poised for continued growth. This is echoed with a number of successful fundraisings we have seen announced in the first half of the year, dedicated to lending to Australian businesses. I look forward to a further trip, later in 2024 and to explore opportunities for our business to be part of this future growth.”

In the first six months of 2024, interest rates have remained stubbornly elevated, with many borrowers still prioritising the cost of capital over flexibility in loan terms – in particular non-cyclical, sponsor backed businesses are opting to work with true senior secured direct and bank lenders, who have lower return targets than their unitranche counterparts. As a result, we have seen the continued and welcome growth of market share for conservative, direct lenders in the European lower/mid-market.

As expected, transaction flow for private equity has remained somewhat subdued as low enterprise valuations, exacerbated by higher interest rates, are forcing investors to hold onto assets for longer in order to make their target returns. As a result, we have seen an increased focus on the financing of buy and build strategies, to grow the value of their existing assets by bolting on small acquisitions to portfolio companies. An effective origination model is therefore more important than ever. Our exclusive and legally binding origination and co-lending agreements with leading banks in all our key geographies have continued to drive our robust pipeline of high-quality loan opportunities, including exclusive access and right of first refusal on off market loans such as those to fund sponsor-backed buy and build activity. This enables us to take a highly selective approach to the borrowers we choose to lend to, including across loans not accessible to any other direct lenders to deliver sustainable performance for our investors. In addition, this innovative origination model removes the need for an expensive internal origination team at a time when competition for talent in the industry has heated up – allowing us to instead focus on building a team with extensive experience of investing, structuring and restructuring loans across multiple economic cycles.

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However, in the second half of the year, we anticipate that defaults will increase to a certain extent. Companies burdened with high levels of financial leverage will continue to struggle under the increased cost of debt putting pressure on debt covenants. Borrowers are further feeling the pressure of inflationary costs, reduced consumer spending and geopolitical risks all of which have an impact on financial performance. As a result, different forms of borrower restructurings will increase, especially for those funds that have lent with aggressive loan structures to cyclical companies. Fund raising will become more difficult for these funds as institutional investors including pension funds and insurers will continue to favour more conservative, income generating direct lending strategies, suitable for matching their liabilities, rather than higher risk strategies which have been negatively impacted by the current environment.

Some borrowers, who have underperformed,  will struggle to find liquidity to refinance their loans as they approach maturity, meaning that only the strongest and most stable companies will find it easy to access the market. The market will become bifurcated with non-cyclical companies able to negotiate good loan terms and more cyclical companies being penalised in terms of cost of borrowing and tighter loan terms. 2024 has been a great year for direct lenders who have been disciplined in their lending approach. These lenders have bene able to get strong yields on new loans and lender friendly protection rights in loan documentation whilst not having had to deal with restructurings in their portfolios.

If 2023 and 2024 have been so far characterised by the rate environment, we anticipate that regulation will be the primary driver of change in the second half of the year, into 2025, when Basel IV set to take effect. We anticipate that this new regulation around capital requirements will raise the cost of lending for banks in certain jurisdictions, as well as reduce liquidity in certain sectors of the market, creating opportunity for direct lenders going forward.”