This article is sponsored by BlackRock
If environmental, social and governance issues were already on the radar of many private credit funds, their investors and portfolio companies, 2020 looks set to be the year that accelerates the integration of sustainable investment and business practices. But what does ESG integration mean in the context of private debt? And how much leverage does a lender really have with management teams when it comes to encouraging sustainability? We explored these and other issues with Sonia Rocher, managing director in BlackRock’s European private credit group.
Why are ESG factors becoming more important for corporates seeking access to capital?
We’ve seen a lot of change over the past few years as lenders and investors have been gathering data and monitoring borrowers through more of a sustainability lens. This development has been happening quite rapidly in private credit, but we’re also seeing it across the liquid credit markets, including in areas such as high-yield bonds and leveraged loans.
Overall, there is a much greater awareness and understanding of how capital can be directed towards the sustainability agenda. For example, we take a long-term view on companies and why they will be winners – ESG and sustainability factors play strongly into this. As an investor, you want to be sure you are backing companies with a sustainable business model and that holds true across private credit, private equity, public equities and fixed income. That means companies increasingly need to demonstrate their ESG credentials and especially their readiness for energy transition to be successful in capital-raising.
How do you think the events of 2020 have played into this trend?
This year has been key to raising the awareness of ESG and sustainability. We have seen so many one-in-100-year events that many of these issues have become impossible to ignore.
The pandemic has highlighted the vulnerability of a range of areas as it has impacted healthcare, employees and global supply chains. It’s clear that the path to economic recovery will have to take full account of the ‘S’ for Social in ESG. There will be opportunities, for example, to invest in companies with sustainable business models using suppliers that are closer to home and create quality jobs. This will help drive the recovery.
Yet we’ve also seen environmental events, such as the unprecedented fires in Australia in early 2020 and those in California later in the year. These have really served to illustrate to the world at large both the significant impact environmental disasters can have and how climate change is having an effect. I think these events will turn out to be pivotal in investor behaviour because they have raised awareness of what the new normal could look like.
The other factor that has really strengthened the case for ESG has been the performance of companies with strong ESG credentials. The events of this year have demonstrated the resilience of these businesses – on the liquid markets, for example, ‘ESG focus’ indices, as defined by MSCI, have outperformed by 230 basis points globally, 240bps in the US and 300bps in Europe, according to Credit Suisse ESG Research in September 2020. This is really helping to direct the flow of capital towards companies that focus on long-term sustainability.
How do you view sustainability when it comes to private credit?
We see companies that really understand ESG factors as long-term winners. ESG has always been a key focus for us in the private credit space because we view ESG risk as credit risk, especially in the mid-market company space. We identify and evaluate ESG risks as part of the underwriting and due diligence processes and if we can’t mitigate or manage an ESG risk, if there’s not sufficient data to work with or if the company’s growth is linked to, for example, deforestation, we will walk away, even if the business is attractive on other measures. This approach is not just because we think it’s the right thing to do, it’s also because we don’t see these businesses as long-term winners – they are not sustainable.
Do you view ESG mainly through a risk lens?
No, we also see it as a business enabler. One of the businesses in our portfolio, for example, produces marketing materials. At first glance, it might look like a company that wouldn’t meet the sustainability threshold because of the large volumes of paper traditionally used by this segment. Yet a deep dive on the company’s ESG credentials reveals that it has helped large, blue-chip clients through sustainability campaigns and has, for example, helped them to reduce paper consumption and waste, and ensured that the complex supply chain meets sustainability targets. The CEO has hired a head of ESG who sits on the company board and is accountable for driving the ESG agenda. He views this as an investment – not a cost – because he sees ESG as a way of winning new customers and having a positive impact on the planet. Our view is that companies like this will outperform over the long run.
What kinds of tools can be used to help with all three of these areas?
There are a variety of tools you can use. We have developed a proprietary ESG guideline and scorecard system that allows analysts to assess ESG risk consistently with parameters specific to industries. It is a vital tool in our decision-making process and is used across our private credit operations globally. It also helps us assess ESG performance at the asset level and in constructing our portfolio. Training for staff is also very important, particularly when it comes to understanding more nuanced risks, such as some of the social aspects of ESG. We also send out an annual questionnaire to portfolio companies so they can report back to us on ESG issues and progress.
And finally, there are organisational methods of tackling this – at BlackRock, our investment teams work closely with the sustainable investment team and the risk and quantitative analysis team, who constantly ensure that our processes are evolving and fit for purpose. Overall, to be effective, you have to approach ESG integration from a number of different angles.
What role can private credit providers play in helping companies integrate ESG and sustainability?
I think we have a significant role to play. There is often the view that lenders can only have a limited impact on companies because, unlike sponsors, we don’t have board seats. I disagree with that because we have a lot of levers at our disposal. Clearly, the first is the binary choice of whether or not to invest and that, in itself, can be impactful. Yet beyond that, we can set ESG targets for borrowers in areas such as waste or water consumption to encourage sustainable behaviour. We can also actively engage with sponsors and the management team to highlight due diligence findings. We also send out our annual questionnaire that helps identify areas for improvement or progress.
Private credit has a particular role to play here in that it typically finances mid-market companies – these are the backbone of the economy. We can help these businesses, many of which may not have dedicated ESG teams, through their ESG journey. They are often too small to access the capital markets when we start our relationship with them, but as they grow we can support them in improving financing and ESG reporting and getting them ready to access the capital markets. This is particularly true for companies that aren’t working with a private equity sponsor.
How do you see ESG momentum in private credit developing over the coming years?
It will continue to develop into a collective approach that encompasses the entire chain from institutional investors to private credit and private equity firms to company management and employees. We are now at a point where there is never an investor meeting when ESG isn’t discussed, so we are moving in the right direction. And this will become increasingly important as younger generations join the workforce and invest their capital because they increasingly care that investors and companies act responsibly in what they do. This will all force the collective mindset away from short-term views towards the long-term sustainability of companies.
Data will become increasingly important and sophisticated. Investors are already driving this, but we are also seeing regulatory moves, such as the proposed EU sustainability reporting requirements for institutional investors.
And finally, ESG inevitably moves along the curve towards impact investing, where there is an intention at the outset to generate alpha and have a positive impact through investing – and here I see a lot of opportunities on the horizon.
What are the challenges of integrating ESG in private credit investment?
There are a few challenges. One is the fact that ESG is highly complex and nuanced and the factors at play can vary considerably across different industries. And while the first step may be relatively straightforward – negative screening, where you exclude certain industries that you know to cause harm – once you dig deeper, you have to analyse a whole array of variables.
This is made more challenging by the fact that access to information can sometimes be limited – that’s especially the case with mid-market companies in which we invest, because these businesses won’t often have tracked their impact on wider stakeholders and the environment. There is no checklist you can use to cover all areas and so you have to analyse each opportunity individually. This isn’t just a private credit issue, though. In liquid markets, there can be issues around the reliability of data – ESG ratings across different agencies don’t always correlate, for example.
And finally, monitoring portfolio companies can be challenging. You really need the right tools to be able to do this effectively.