Insights

Insights series / 02 August 2021

ESG in private debt

ESG in private debt

Europe’s red hot private debt market is going green

By Alex Di Santo and Andrea Lennon

Led by investors and regulation, the push for environmental, social and governance (ESG) sustainable investing has become mainstream in Europe and is seeing strong growth in the US. It is clear that all market participants want to be a part of the solution and make a meaningful contribution. For private debt managers effectively incorporating ESG principles into their businesses and investment processes calls for the collection of new data sets, as well as modifying the process and interacting with new stakeholders. With time, a better understanding of the data sets and the standards will become the norm.

Alternative asset managers in Europe are leading the way for ESG: 63% of alternative assets invested for the continent are already managed under sustainable principles which have been systematically incorporated into the investment decision. Though the green share of the $850bn private debt fund market is relatively small; all data providers agree that that share is growing every year.

Any fund with long dated debt should take a long dated view of the world. And a long dated view of the world must embrace ESG. So what does ESG for private debt look like and how will these principles incentivise both borrowers and private debt managers to implement ESG in their businesses and portfolios?

Case study: what private debt players are doing with ESG

Case study: what private debt players are doing with ESG

The fact is, private debt managers and their investors are already in the business of taking long term views. The discipline of long-term thinking and analysis around a corporate’s ongoing credit quality is well suited to long-term thematic issues such as emissions and climate change, energy transition, company ethics and inclusive and fair business practices. Investors certainly expect their capital to be deployed amongst companies that will emerge the winners in these and other ESG-related areas.

Then there’s direct influence. Private debt managers do not typically hold board seats in the corporates they lend to, that's clearly not the only way to influence companies. Some managers have a policy of direct dialogue with management teams, in an effort to educate and challenge them on ESG issues. It is also possible to win influence by working with other existing or prospective investors in the business to ensure better ESG practices and outcomes. Further, the view that ESG is a drag on performance is behind us. If we look back only a few years ago the worry for pension trustees and fiduciaries was that ESG may create an overall performance drag, however with already $40tn being managed with an ESG lens, it demonstrates that a well-run company that embeds ESG in all that it does has outperformed its peers.

The very decision of whether or not to lend a company capital is in itself significant and should in any case bring a management team to the table for further engagement around ESG. In fact, Barings Bank did precisely this in 2020, in a deal involving the listed company, Questel.

Barings offered financing which included an annual review of the margin for the credit facility, based on the achievement of five pre-defined ESG criteria. Because the test is annual, it requires the borrower to be committed to the ESG criteria – and because commitment to the criteria directly correlates to a reduction in the cost of its capital, the firm is suitably incentivised to make good on that commitment. The more criteria the company meets, the larger the cost reduction.

Managers who are similarly able to integrate ESG into their portfolios will undoubtedly be met with approval from investors globally. 

Challenges

Challenges

There are challenges at both a business and portfolio level. When implementing ESG for their own businesses, managers will need to navigate multiple different frameworks – there are more than 15 at the time of writing – each of which is complex as it is nuanced.

ESG targets will need to be agreed together with a plan on how to achieve them: firmwide policies will be established to encourage adherence to the chosen framework, with KPIs set against those policies in order to monitor progress. Information needs to be gathered for each of the KPIs consistently throughout the year, which can be challenging in itself: managers will need the right tools for the job to be able to do these things effectively.

At the portfolio level, there’s also much to consider: there are no standard checklists, an abundance of frameworks for large corporates but very few for middle market firms. ESG considerations may apply at any point in the investment’s lifecycle and factors can vary across the different industries of the underlying portfolio companies. Once a manager has moved past negative-screening, which is comparatively straightforward, the variables to be analysed for each holding only increases.

With the need to demonstrate compliance with regulation much emphasises on planning, resourcing and appropriate expertise for effective integration of sustainability risks is key. Moreover, the data consumed needs to help the participant in the value chain assess investment opportunity and potential risks through an ESG lens as well as a traditional data lens.

Another immediate challenge for all the stakeholders including fund managers, advisors and service providers is the need to assess decision-making procedures ensuring that ESG sustainability risk factors are embedded, understood, and documented. Further challenges are introduced when portfolio companies have gathered limited or no information around ESG factors, or the data passed on isn’t entirely reliable. This tends to affect small to middle market companies the most, although these are issues for every asset class, not just private debt. It's worth noting that data that doesn’t come directly from a portfolio company can come from other sources, such as the firm’s sponsors, banks and other private market backers, in the form of GRESB assessments or SASB (Sustainable Accounting Standards Board) criteria, for example.

The future of ESG in private debt

The future of ESG in private debt

Though ESG was introduced to private debt relatively recently, we would expect ESG to make the same sort of journey within this asset class that we've seen it make to date in nearly every other one.

Momentum will continue to develop over the coming years and will eventually incorporate the entire investment chain, from underlying portfolio companies through to managers and their investors. To reach this outcome, both investors and regulators, spurred on by public opinion, will continue to move towards better ESG practice. This is already happening, for example with the European Union’s Taxonomy Regulation, where social and governance factors will join the current set of environmental factors by the end of 2021. This will continue to cascade to private debt managers - who are today already unlikely to be having meetings with investors and corporates where ESG considerations are not being discussed.

As has happened with other asset classes, we would also expect talk of ESG to turn into conversation and action around impact investing. That is, private debt investors and managers setting out to generate returns through activity that is aimed at having a specific net positive impact on the environment or society, for example - not just to have a net neutral impact.

Such shifts are likely to continue to make headway in other jurisdictions around the world such as in North America, which still lags behind Europe on ESG. It will also force a shift away from short-termism, rewarding firms across the investment chain for long-term thinking. Ensuring ESG methodology, policies and processes are embedded in every step of the value chain will be key to standardisation of data. With the European disclosure and taxonomy directives, regulators are looking to set out what information managers and advisors should disclose, it will take time for all the stakeholders to agree a unified approach which would result in reporting that is clear, easily digestible and timely.

In the near term, we expect the share of ESG-related private credit assets to continue to increase steadily, as more existing managers and new launches emphasise this in response to growing investor demand. Those who are able to invest in better processes and technology themselves, or can outsource to firms who can provide that, are likely to bring an industry-wide boost to ESG as they raise the bar for greater incorporation and measurability of ESG principles. While industry gets more comfortable with standards, the more information around the ESG factors and methodologies applied will be a critical risk mitigant against any future claims of greenwashing etc. This is something managers will benefit from directly, as it will only heighten their appeal to investors across the spectrum.

Related articles

17 May 2021 / Insights series

Venture debt’s turn to shine

12 July 2021 / Insights series

4 reasons direct lending is growing in Europe

15 July 2021 / Insights series

Debt for control strategies