Arcmont on lenders leveraging influence to drive ESG

As credit managers get more sophisticated on ESG, the tools they can use to drive progress in their portfolios are also advancing, says Nathan Brown, chief operating officer at Arcmont Asset Management.

This article is sponsored by Arcmont Asset Management

How have you seen the approach of private credit managers to ESG evolve over the past two years?

Nathan Brown

ESG is a journey for asset managers, and that’s true for credit managers as much as it is across the broader asset management spectrum. That journey starts with understanding what ESG is and what your organisation stands for; truthfully, there were probably still funds a few years ago that didn’t know what ESG was.

But then firms move to putting a policy in place, introducing basic screening procedures and doing some qualitative analysis and reporting. Firms then progress, expanding their exclusion policy, producing more detailed analysis and reporting, and eventually integrating ESG throughout the investment process.

Ultimately, ESG should be something managers think about all the way through from due diligence to exit, with the most mature funds using quantitative metrics and encouraging good ESG behaviour among their borrowers by introducing initiatives like margin ratchets on their loans.

People are at different stages on the journey, with some at the beginning and others starting to push the boundaries. In the white paper we have just released in conjunction with KKS Advisors, we classify investors as either initiated, integrated or advanced, based on their progress along the ESG journey.

How far are you along that journey?

At Arcmont, we believe we are a long way along the path. We put our first ESG policy in place back in 2013 so we have had some time to develop our thinking. Now ESG is fully integrated with comprehensive policies including an advanced exclusion policy. We also produce detailed qualitative and quantitative analysis, offer borrowers environmental and social related financial incentives, and give investors comprehensive reporting.

ESG is a fast-evolving landscape, a lot has changed over the last few years in both the public and private markets, with the public markets being more advanced but private markets are now catching up.

How can debt funds be most effective in driving ESG progress within their portfolio companies?

The key word here is engagement, we need to engage with portfolio companies on this. One of the biggest challenges for private credit is that they are not owners of the business, so the sponsor has a lot more control. The lender has to engage with both the management and sponsors.

As a vice-chair of the Alternative Credit Council, I’ve been involved with their recent work on ESG. One of the things we have been pushing for is a more joined-up approach between credit managers and private equity. Ideally, we should all want the same thing; ultimately, we have a similar set of investors who are pushing for action on ESG, so if we are better aligned, we should be able to make progress faster.

Another challenge that credit funds face in the upper mid-market is with respect to the availability and quality of ESG data. Borrowers typically aren’t required to produce the level of data larger public companies make available.

The advantage we have, however, is closer interaction and proximity to borrowers and sponsors. If you’re operating in public markets, as an asset manager you can’t easily phone up the leaders of the businesses you are lending to for ESG answers, but you can on the private side. So, whilst the data might not be readily produced, the ability to have discussions is there.

The other way to drive ESG progress is by offering financial incentives, which those of us further along the journey are now doing via margin ratchets. At Arcmont we offer borrowers a discount on the margin should they meet pre-agreed environmental or social targets.

What sorts of things is Arcmont currently doing to promote ESG among its borrowers?

We are particularly proud of our Target Improvement Plans. A number of market participants now offer financial incentives via interest rate discounts to encourage their portfolio companies to improve their ESG performance. One option is to set a list of criteria where you say to portfolio companies that if they do these three set things they will get a reduction of maybe five basis points on the margin.

We considered that but we didn’t think it was necessarily going to have a meaningful impact for each specific company. So, instead, we decided to come up with a bespoke plan for each of our portfolio companies and – through a collaboration between ourselves, our third-party adviser, the borrower and the private equity sponsor – we devise a bespoke TIP for each specific borrower.

In general, it will consist of three staged environmental or social targets, and as each target is achieved the borrower gets 2.5bps off of the margin on the loan. We like the fact that it is bespoke, it’s not generic.

Our TIP focus is always on the environmental or social aspects of ESG, because governance is something that’s always been important for us and our investors. Good management teams and sound governance have been an integral part of investing since investing began.

Another key element is our bespoke scoring system, with transparency around the analysis. That allows us to shine a light on issues within the portfolio. We are also working on a standard template for collecting ESG data from our portfolio companies. Not only will this improve our data collection but it will encourage borrowers to look at key ESG metrics, highlighting areas of concern and areas where they can improve.

What are the advantages of Target Improvement Plans?

Because each plan is made up of three progressive targets the borrowers can demonstrate improvement over time. We offer TIPs and margin ratchets on all of our primary originated loans now. The process is hard work because we have to put our heads together and come up with something bespoke to the borrower, but the results should be more meaningful to the company in question. The challenge is finding something that can be impactful but is possible within the constraints the specific company faces.

How do you see the recent rapid advances in ESG practice at debt funds evolving going forward and what do you expect to see in terms of future developments?

There are four principle developments to watch. First, as people move further along the ESG journey, it will not be long before the majority of managers will be focused on quantifiable as well as qualitative metrics. We will also quickly start to see more lenders introducing margin ratchets and more funds with more detailed exclusion policies. We will see fast progress now along that spectrum.

Second, I think we will see – helpfully – more standardisation, particularly in terms of the data that is expected of portfolio companies. We are pushing for a standardised data request form and we hope that is something we can help develop alongside the Alternative Credit Council. If every portfolio company knows the specific metrics every lender is going to be requesting, it will be a lot easier to manage. So, I think we will soon start to see standardisation of data and reporting templates.

The third big theme is climate, which is an area where investors are starting to ask a lot more questions and managers are having to react. Every manager will need a climate policy and needs a good handle on the impact that their operations have on the climate agenda.

Finally, there will be an increasing debate about sustainable outcomes. At the moment, people talk about ESG integration as a way for managers to mitigate ESG risk in order to produce better financial outcomes.

As we move forward, people may become more focused on sustainable outcomes and sustainability will be seen as a measure of performance in itself. Will financial returns be the only metric by which managers are judged? As the ability to measure those sustainability outcomes matures, so that question will come into focus.

For now, the focus is on standardisation of data, and then producing, measuring and analysing that data, and we are currently working with an innovative technology solution provider to help us. It’s a fast-evolving space and one we intend to stay at the forefront of. It will be exciting to see where we go from here.

At a fund level, what do LPs expect managers to be doing in their own businesses today?

Basically, LPs expect managers to be doing more. In the same way that the private credit industry has come a long way in the last two years, so too have investor expectations. Geography plays a part in that, with Scandinavian investors really at the forefront of this conversation, followed by other European LPs. There is a perception that US investors are behind, but as the recent AIMA data reveals they are not as behind Europe as some people think.

Integration of ESG across the fund manager is what LPs are most focused on – it is not enough just to have one person with knowledge about ESG, it needs to be fully integrated.

There is a focus among LPs on the Sustainable Finance Disclosure Regulation and climate change, with climate change almost becoming a topic of its own, particularly in the wake of COP26. Climate change is increasingly important to investors, and we are about to publish our new climate policy, which includes a commitment to go carbon neutral as a manager.

On other issues, like diversity and inclusion within our business, different LPs have different priorities. I would say US investors are far more advanced in their focus on diversity and inclusion, while Europe may be leading the way on the environment but that’s just my anecdotal experience.