The following section explores different responsible investment approaches, emerging industry trends and thought leadership in more detail, including:
- Integrating ESG factors into private debt investment decisions;
- Engaging borrowers on ESG issues;
- Thematic investing, impact investing and green loans;
- Alignment between lenders, co-lenders and private equity sponsors about ESG issues;
- ESG reporting from managers to investors; and
- Operationalising responsible investment.
Integrating ESG into private debt investment decisions
Investors can integrate ESG factors into investment decisions and engage borrowers on ESG issues at various stages of the investment process, as shown in Figure 9. The more standardised ESG integration methodologies available to public markets investors – based on desk research or third-party data and analytics services – are generally not feasible for private market investors due to the lack of publicly available ESG data for private companies. This presents both a challenge and an opportunity for investors, given their ability to exploit imperfect market information and leverage relationships with borrowers.
Which ESG issues to consider?
Investors can consider ESG factors at various levels:
- Macro view – how do ESG factors, such as resource scarcity and climate change, affect economic growth?
- Sector view – how do ESG factors, such as shifting consumer tastes or regulatory changes, affect business at a sector or industry level?
- Micro view – how is exposure to, and management of, ESG factors linked to company financial performance?
As previously discussed, ESG integration should not be seen as a rigid framework or checklist of issues in isolation. Some ESG issues will be more material to companies in certain sectors than others, depending on whether they are focused on services, manufacturing, natural resources and so on.
There are a number of different frameworks which can help investment teams when considering which ESG issues to assess as part of their due diligence:
- The Sustainability Accounting Standards Board (SASB) Materiality Map26 aims to identify the ESG issues that are most likely to be material for 79 different industries, and provides a useful starting point for investors to consider ESG factors for analysis;
- Development finance institutions (DFIs) are generally advanced in their assessment of ESG risks among investee companies, given their exposure to a wide variety of corporate and country risks, and legal and regulatory frameworks.
- The International Finance Corporation (IFC) Environmental and Social Performance Standards define investee companies’ responsibilities for managing environmental and social risks, and provide a useful framework for investors to consider issues such as land resettlement, biodiversity and indigenous people’s rights27. While the Performance Standards were conceived with emerging market investments in mind, they are also applicable, in large part, to investments in developed markets.
- The CDC Group ESG Toolkit provides a foundation and reference point upon which investors can develop their own proprietary ESG due diligence frameworks28.
- Some DFIs, public entities and private investors produce ESG checklists. Examples of publicly available ESG checklists can be found in Appendix III.
- Real estate or infrastructure debt investors may wish to consider the GRESB assessments29, which enable users to benchmark the ESG profile or performance of real assets and real asset funds on a global basis.
All the portfolio companies have employees so, by definition, there is a social risk element to all of these companies in terms of how they treat their employees and how they govern their business
In addition to these frameworks, Figure 13 lists other examples of ESG issues raised by interviewees for this project. The list is comprised of a mix of values- or norms-based screening criteria and drivers of economic or financial risk and opportunity.
Again, we stress that ESG issues should not be seen as a checklist, but these examples should prompt investors to consider which issues might be most important to the companies to which they lend.
Figure 13: selection of ESG factors mentioned in investor interviews, representing both norms-based factors and drivers of financial risk and return
Obviously, governance is immensely important in terms of private debt. We insist on the ‘G’ but, together with investment managers, we also look at the ‘S’ and the ‘E’.
Which entity to consider?
Investors also need to consider which business entity their analysis should focus on – parent, subsidiary or project. Investors should assess a subsidiary’s level of autonomy before determining whether analysis of the parent company alone is sufficient. If a subsidiary is operating under the policies of the parent, there may be no need to perform additional due diligence on the subsidiary. If the loan involves a specified allocation of proceeds, then additional analysis may be needed on that allocation or project.
Inevitably, as sustainability becomes a core requirement for investors, there is a danger that a box-checking culture could develop. What is needed is a clear strategy to focus finite ESG engagement capacity on those areas where ESG risk is greatest, but also where the potential positive impact of marginal sustainable investment is highest
Allianz Global Investors
How to analyse ESG
ESG research comprises analysing data collected from one or more of the following: desk research; third-party providers; technical experts; legal due diligence documents; co-investors (either lenders or private equity sponsors); ESG questionnaires; and meetings with the senior management of the borrower. While a lender is unlikely to commission a one-off ESG report, it is quite likely that a private equity sponsor (if involved) will have produced one that it may be prepared to share with the lender. Analysis of ESG factors should be aligned with the investment horizon, and the investor will need to determine whether issues such as climate change will affect an issuer in the short, medium or long term.
Our due diligence process on a company in northern France highlighted an environmental issue that would cost the business. Further due diligence on the capex required to upgrade an industrial site to meet environmental requirements (of €4m-6m just to be compliant) directly affected the credit analysis, so we chose not to invest
For emerging market deals, development finance institution expertise on ESG can be invaluable to lenders, as the level of due diligence required is likely to be greater than for a deal carried out in more developed economies.
ESG integration in the context of private debt has specific characteristics. ESG integration for public markets practitioners generally involves integrating ESG factors into traditional valuation models (e.g. discounted cash flow models), which can be sensitive to incremental differences. Investment decisions in private markets tend to be more binary, as investors tend to consider whether or not they are comfortable with the overall risk.
When significant ESG issues arise in the due diligence perspective, it’s a binary decision [to invest or not]. It’s not something you can price in
Allianz Global Investors
[We] believe that, in the future, a company’s ability to access capital will depend on its ESG performance.
LGT European Capital
Using questionnaires to gather ESG data
Investors face a significant ESG information gap due to the lack of public reporting obligations for private companies. Around half of the investors interviewed for this report have created ESG questionnaires to be completed by borrowers to overcome this challenge in an efficient manner. Questionnaires can be quantitative, qualitative, or a combination of the two. Investors interviewed for this report raised the importance of educating potential borrowers on their reasons for requesting ESG information, and to demonstrate a robust understanding of how ESG issues might affect their business model. Investors can act as a mirror to reflect corporate performance and, while most small businesses lack the resources to produce annual ESG reports, ESG questionnaires can be a relatively efficient way for investors to identify a borrower’s important ESG characteristics.
Our ESG questionnaire is a real chance for [borrowers]. We have a positive view using both our analysis and a third-party report. We don’t want to name and shame. We actually send them a summary of their annual report, for discussion
Lyxor Asset Management
Many investors noted how important it is to avoid burdening borrowers with unnecessary reporting requirements, and that surveys of around 10 questions are more likely to solicit constructive responses than those of 40 or 50 questions. At the same time, those investors commented that borrowers’ preparedness to answer investor ESG inquiries has noticeably improved in recent years. Avoiding reporting fatigue by aligning with other lenders is another way for investors to support greater ESG transparency. Ultimately, investors may be able to benchmark borrowers (assuming the numbers allow for a meaningful benchmark) and even encourage competition between portfolio companies.
Today, we not only have better acceptance [of ESG] from companies, but there is also appetite for feedback, comparison and best practices. And this is where we can play an important role, because we have access to the data from the other companies in our portfolio. We formalised the output of our [ESG] survey across the entire portfolio on a number of key KPIs, so that an individual company can compare itself to companies of similar size
LGT European Capital
Considerations for the secondary private debt market
The secondary market for private debt is both nascent and, given the lack of liquidity in the private debt market, relatively small. Nonetheless, secondary market investors may still consider the ESG profile of borrowers in the same way as a primary debt investor would. The challenge for secondary investors will be the even more limited access to ESG information and management than is faced by primary lenders. Secondary deals will typically mean fewer opportunities for investor engagement with the borrower. Similarly, the capacity of an investor to conduct detailed due diligence is most likely less than for a primary deal, due to less access to company management, and must instead be partly reliant on the primary investor’s due diligence. Aligning ESG expectations with the primary debt holder and/or sponsor can help to ensure that secondary transactions meet predefined minimum requirements.
Borrower reporting requirements for ESG analysis
As with investor reporting, there is no clear consensus on best practice reporting on ESG issues - how companies do this depends on a range of factors, such as their size, resources, expertise and relationship with their investors.
In our view, a poor approach to ESG is symptomatic of a more general unwillingness to embrace transparency
Some investors stipulate regular ESG reporting in the loan terms but, at a certain size, there is a general expectation that the borrower will publish some form of corporate ESG policy and reporting to address specific ESG issues.
The worst way of trying to impose reporting is asking for something they don’t need. That does not encourage [borrowers] to respond. It is better to ask: ‘Can you please share what you have?’
Engaging borrowers on ESG
As discussed, engagement is a useful tool for managing and monitoring ESG risks. Lenders can engage borrowers throughout the investment process, from initial preassessment through to the post-transaction phase. While lenders lack the access to management that shareholders enjoy, there can be intense exchanges between borrowers and lenders during the initial assessment and due diligence phases.
The direct, private relationship between loan provider and borrower, and the contractual nature of the loan, create relatively frequent contact between the parties that permits typically greater engagement than in the bond market
- Loans involving smaller numbers of investors will inevitably afford each one of those investors greater influence than those involved in a public debt issuance or leveraged loan.
- Often the best opportunity to engage is just before a transaction, when the loan is mission critical and the borrower is most attentive.
- As many smaller private companies lack dedicated investor relations or ESG personnel, lenders will need to seek out an ESG champion within the senior management team to maximise the effectiveness of their engagement.
- Strong working relationships and regular dialogue among borrowers, lenders, private equity sponsors and co-lenders is crucial to ensure alignment between all parties.
- Many investors consider themselves to be playing an educational role – explaining to borrowers why they are interested in ESG information and what they are looking for.
- Borrowers are typically receptive to engagements on ESG matters, and many appreciate the opportunity to demonstrate their commitment to and their management of ESG issues.
- Given the lack of formal private market ESG benchmarks, many borrowers appreciate the opportunity to benchmark themselves against peers in the lender’s portfolio.
Thematic investing, impact investing and green loans
Motivations for impact or outcome-driven investment
Policy makers around the world are reacting with increasing urgency to the most pressing sustainability issues, such as climate change. At the same time, many investors are actively targeting investments which generate positive environmental or social outcomes through good corporate practices, or through the products and services that investee companies offer. Private debt has the potential to provide a significant proportion of the capital these companies will need.
Impact investment has often been (rightly or wrongly) associated with compromised financial performance, but it is increasingly seen as an approach that does not necessarily lead to below-market returns, and can be compatible with investors’ fiduciary duties. Indeed, certain investors target solutions to critical environmental and social issues specifically because of their potential to outperform traditional businesses over the medium and long term.
The main characteristics of private debt outlined above present both advantages and challenges as a means of allocating impact capital (see Figure 14).
Figure 14: the case for using private debt to gain exposure to thematic, impact or green investments
Since loan agreements can often be bilateral, there is the ability to contractually bind the borrower as to its green loan obligations. If a [borrower] fails to use the proceeds for green purposes, this can cause an event of default or trigger in-built penalties until the borrower cures it
Green loans are defined as: “Any type of loan instrument made available exclusively to finance or re-finance, in whole or in part, new and/or existing eligible green projects.” Green bond issuance has grown exponentially since the European Investment Bank issued the world’s first official green bond in 2007 and the green loan market holds equal promise as a large-scale source of capital for solutions to climate change and other sustainability challenges. As of July 2018, US$32bn of green loans had been issued globally37. The Green Loan Principles (GLP), developed by the Loan Market Association and largely based on the International Capital Market Association’s Green Bond Principles, provide a high-level framework of market standards and guidelines for the green loan market38. They are designed to ensure consistency and integrity in four areas:
1. Use of loan proceeds;
2. Process for project evaluation and selection;
3. Management of proceeds; and
To ensure consistency and credibility to loans labelled as ‘green’, ‘social’ or ‘sustainable’, the GLP appendix includes an indicative list of categories of projects considered to be eligible for a green loan label, including renewable energy, pollution prevention and clean transportation.
Positive incentive loans
Similarly to green loans, positive incentive loans (PILs) are associated with positive environmental or social impact. The key feature of a PIL is that a proportion of the financing cost is linked to the ESG performance of the borrower, as judged by independent ESG research providers.
It is vital that investors can clearly see what their money is doing to improve peoples’ lives and the environment whilst providing stable financial returns
Examples of thematic or impact investments in private debt
- French food company Danone recently signed a .2bn syndicated loan where the cost of capital is directly linked to specified goals based on sales from Certified B Corp subsidiaries and the combined ESG ratings from two independent research providers40. In this deal, a proportion of the cost of capital can either rise and fall from the base rate, depending on performance.
- UK-based M&G Investments manages a private debt fund that targets positive social and environmental impacts. In February 2017, M&G provided a longterm ’85m loan to UK-based housing association One Housing. The loan is being used to increase the number of affordable properties developed by the company.
- A portfolio of three UK wind farms with a combined capacity of 151 megawatts reached financial close in 2017 after securing a ’210m debt package. Developer Banks Renewables received ’140 million of the total from Macquarie Infrastructure Debt Investment Solutions, which provided long-term liquidity comprising of both fixed rate and inflationlinked tranches.
Historically, we have had the belief that any company can be a very strong ESG company, whatever its environmental footprint. It’s all about the trend, the effort and the progress. We never considered exclusions or sectors to be very relevant in a holistic ESG approach […] We are not making an impact if we are only investing the sectors that are green
LGT European Capital
Alignment between lenders, co-lender and private equity sponsors on ESG
We always try to have an engagement dialogue with other debt investors and with the [private equity] sponsor through regular meetings, not just the odd one-way email
SWEN Capital Partners
Aside from engaging borrowers, investors should also consider combining and streamlining efforts on ESG with other lenders and (where applicable) private equity sponsors. Private equity investors often hold the relevant ESG information a lender needs to complete a satisfactory due diligence process. A strong relationship and knowledge of the sponsor’s own approach to responsible investment should help to build a lender’s confidence further. The feasibility of such collaboration will depend on the respective private debt strategy. Hence, while participants in syndicated loans will be pressured to work towards the lowest common denominator regarding ESG due diligence, investors involved in unitranche or bilateral loans may see value in collaboration on ESG risks and will be able to determine their own thresholds.
With considerations about investor collaboration in mind, French private equity industry association France Invest has initiated a programme to identify best practices and issue recommendations (possibly including suggested clauses) for collaboration and dialogue on ESG between co-lenders and sponsors.
We tend to believe that, when you have got a private equity sponsor involved, the likelihood of [ESG] issues [materialising] is lower
Assessing the responsible investment approach of private equity sponsors
Given the access that private equity sponsors have to company management, many of the private debt investors interviewed reported that they engage those sponsors with proprietary ESG questionnaires and/or review their publicly available PRI Transparency Reports to assess their commitment to responsible investment43. The focus for such investors is typically similar to that of a private equity LP: sponsor commitment to ESG considerations; their responsible investment policies; their internal resourcing of responsible investment; and examples of their responsible investment procedures in practice.
If you are dealing with a very large transaction with lots of potential lenders, you may have less influence. Often what is more important is your ESG views on the sponsor rather than the actual company you are lending to
[Our approach is,] if the sponsor is a major player in ESG, we will a) evaluate the acquisition due diligence…on the equity side, and b) we will agree with them on how we are going to monitor ESG issues during the holding period
Figure 16 shows an example from a lender of a scoring framework used to assess sponsor commitment to responsible investment. Furthermore, the Appendix of this report includes the PRI Private Debt Investor ESG Due Diligence Questionnaire. The questionnaire is based in part on the PRI Private Equity LP Due Diligence Questionnaire and is intended to encourage dialogue between investors and managers. The questions may also help to frame dialogue between lenders and sponsors.
Figure 16: example of a manager rating system used by European fund-of-funds LGT European Capital to assess fund managers
|1||Manager is genuinely committed to ESG, with institutional processes in place. Applies ESG criteria in investment decision-making, is an active owner and reports on ESG|
|2||Manager has taken steps to integrate ESG into its approach and investment process. Process is institutionalised, but manager may not follow through at all levels (e.g. reporting)|
|3||Manager demonstrates some commitment to ESG or has begun certain initiatives, but lacks institutionalised processes|
|4||Manager demonstrates little or no commitment to ESG|
ESG reporting: manager to investor
The private debt industry has yet to reach consensus on the best ways for managers to report on ESG to investors, and reporting activity seems to be lagging relative to other asset classes. This may be a reflection of a lack of demand from investors, but interviewees agreed that this trend is now turning. The PRI’s report, ESG monitoring, reporting and dialogue in private equity46, provides useful guidance on this aspect of responsible investment. It includes the following suggestions:
- Create a robust yet flexible reporting system that suits the needs of both LP and GP;
- At the manager or GP level, reporting should focus on responsible investment policy, the people responsible for delivering that policy, and the procedures used;
- At the portfolio level, some managers are starting to report on the ESG ’profile’ of their holdings, although this may have to be done in aggregation rather than at the individual portfolio company level, due to legal agreements between lender and borrower;
- ESG reporting should focus on incidents and any other material changes to the ESG profile of an individual holding; and
- Managers are, increasingly, reporting ad hoc case studies of positive outcomes, which can provide investors with additional insight into how they manage certain ESG issues.
We tend to report to all our investors on a summary of our survey [of portfolio companies] every year, on some key KPIs, and both the response rate and performance. For this year, the response rate was in excess of 90%
LGT European Capital
You need to hear from a range of people [ … ] You also need to hear from the people who do the monitoring. The approach to workout – how the manager treats distressed situations – is very important with private debt and very much has an ESG dimension: is it consistent with ESG principles, i.e. not fee-generative but really involving working with the companies to make sure sustainability and governance aspects are a high priority?
Operationalising responsible investment
One of the first hurdles many investors face is how to operationalise responsible investment within their organisation: which staff members should take what responsibility for the various internal procedures, and how should the work be resourced? The PRI does not prescribe a single approach in this regard, but notes that investors typically formalise their responsible investment policies and procedures in a phased approach. There is, however, general consensus that best-practice responsible investment is fully integrated into the organisation and not treated as an addon only to be used for marketing purposes. An integrated approach typically involves a centralised ESG function that can coordinate ESG champions across different teams, including compliance, research, portfolio management and marketing.
We believe that, in the long term, there really will be a differentiation of a borrower’s capacity to access capital or cheaper capital, depending on its ESG performance
LGT European Capital
Buy-in at the highest levels is essential, and it is also important to incentivise staff and educate them on emerging ESG topics where necessary. In terms of the actual responsible investment process, managers should ensure an ESG lead attends all deal flow meetings, investment committee meetings and major investment decision sign offs, and wields a veto over deals that do not meet predetermined ESG criteria. Many investors also now include a mandatory ESG section in investment memorandum templates and investment committee meetings.
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