As ESG moves up the agenda for lenders, most are now increasing their focus on ESG credentials at the very start of the investment process by devoting resources to ESG due diligence.
Claire Hedley, ESG director at 17Capital, says: “ESG due diligence is now widely accepted as a standard part of a due diligence process. In most instances, it has evolved from a light-touch checklist approach to a more sophisticated and detailed approach that includes both qualitative and quantitative elements.
“Investors want to understand specific policies, procedures and initiatives on climate, diversity and other ESG topics. There is increasing focus on data so that ESG objectives can be quantified and progress against targets can be measured over time.”
The process and approach varies between lenders. Davide Stecchi, managing director in underwriting at Arrow Global, says: “When it comes to a specific investment opportunity, the first thing we do is ask whether an investment is right for us. Following an upfront screening process that includes some mandatory exclusions, the origination team starts by identifying any ESG risks. As we move into the formal due diligence, an essential part of the underwriting process, we then collect, analyse and assess those ESG considerations in greater depth, often involving third-party advisers where necessary.”
Michael Curtis, head of private credit strategies at Fidelity International, says that Fidelity embeds a full ESG assessment into its structured due diligence process – one carried out by its own team as part of the standard investment process: “We firmly believe that an ESG assessment should not be a separate process, or carried out by a third party, not least because it is increasingly difficult to separate ESG risks and opportunities from broader commercial considerations.”
Challenges can arise due to a lack of harmonisation in approach. Stéphane Badey, partner at Arendt, says the problem for the borrower when it comes to due diligence is that there is no harmonisation in terms of requests, so different asset managers have varying processes and requirements. “Every single entity has its own due diligence framework, so that is not easy for a borrower to navigate,” Badey says.
Neale Broadhead, partner at CVC Credit, agrees there is still progress to be made: “Despite the clear observation that ESG-specific due diligence can help map borrowers’ existing control systems and ESG commitments, such information is seldom made available as part of diligence packs. However, we see the market realising rapidly that lenders can use it to structure bespoke financing, which incentivises the transition to a sustainable future.”
Following the rapid rise of energy prices over the past year, a reduction of overall energy use and improvements to energy efficiency have become key economic priorities, particularly in Europe.
Advocates of energy efficiency have spent years pointing out that the greenest energy is the energy we don’t use. However, progress towards greater energy efficiency has been limited. According to the International Energy Agency, global energy intensity improved by just 1.3 percent a year between 2016 and 2021, falling far short of the 4 percent annual improvement the IEA says is needed to achieve net-zero emissions by 2050.
The Russian invasion of Ukraine, with its massive impact on energy prices, has brought energy efficiency back into the spotlight, adding an economic imperative to the environmental rationale for conserving energy.
Private debt managers recognise the importance of incentivising borrowers to use energy more efficiently, notably for real estate loans. Lenders often include criteria around making buildings and operations more energy efficient as KPIs in sustainability-linked loans (SLLs). Energy usage is, in fact, specifically included as a suggested indicator in SLL guidelines produced by Japan’s Ministry of the Environment in 2020.
Requirements for real estate loans to be considered green may include a commitment to energy efficiency. As Thomas Garnier, originator in Natixis’s green and sustainable hub, told Private Debt Investor last year: “In a refurbishment, to be eligible for a green loan, the borrower would need to demonstrate that such renovation will improve the building’s energy efficiency by at least 30 percent in absolute terms.”
Does ESG come at the expense of financial returns? This question has loomed over sustainable finance for decades, with critics of ESG never satisfied about the answer.
The debate has plumbed new depths this year with the anti-ESG backlash in the US. While announcing restrictions to prevent state pension funds from taking ESG into account in investment decisions, Florida governor Ron DeSantis declared in August: “Corporate power has increasingly been utilised to impose an ideological agenda on the American people through the perversion of financial investment priorities under the euphemistic banners of environmental, social and corporate governance, and diversity, inclusion and equity.”
But the notion that factoring ESG into investment decisions harms returns finds little support among private debt managers. In fact, considering ESG factors that may impact a company’s value is self-evidently an essential part of good underwriting.
“We have always found addressing ESG factors central to our ability to deliver attractive returns,” Kevin Magid, president of Audax Private Debt, told us in May. “As private debt investors, we carefully identify material ESG factors early in the underwriting process and continue to monitor these factors during the holding period of the investment.”
A trade-off with returns is more likely at the impact end of the responsible investment spectrum. Investments intended, for example, to benefit underserved communities can entail higher risk and offer below market rate returns. Those who believe this represents a “perversion” are, of course, under no obligation to allocate to impact funds.
Having a diverse team is critical for innovation to thrive, so firms are making steps towards a more inclusive future.
“A diverse team, with different thinking styles and visions, will bring deeper discussions and more innovative ideas and solutions,” says Coralie De Maesschalck, head of CSR and ESG at Kartesia. “It also allows us to retain our current employees and to attract great new talent.”
Research by the IFC found that gender-balanced teams at private equity and venture firms can produce up to 20 percent higher net IRRs.
Considering this, private debt firms have been upping their efforts when it comes to hiring women. Global advisory and executive search firm Jensen Partners’ most recent private debt industry diversity snapshot revealed that for front-office distribution roles, women made up 43 percent of hires during 2020-21, while they comprised 51 percent of hires between 1 January 2022 and 26 May 2022.
In addition, more and more firms are setting diversity targets. Esther Peiner, managing director and co-head of private infrastructure in Europe at Partners Group, adds: “The fact that organisations are willing to set goals on gender diversity, because they understand the strategic importance, is an achievement in itself.”
However, trying to retain diverse talent can be a cause for concern. An Investec survey found 25 percent of women planned to depart their firms in the near-to-medium term, compared with only 16 percent of men. “The reality is that many people still feel as if their gender is a potential obstacle to their promotion pathways,” says Ben Way, group head of Macquarie Asset Management.