This article is sponsored by CORDET
The ESG landscape in private debt continues to evolve at a very fast pace. Back in 2014, CORDET signed the United Nations’ Principles for Responsible Investment and created its first formal ESG policy. These were important milestones. However, the world has moved a lot further over the past few years and today these steps would barely constitute “entry-level” ESG in private debt.
The development of ESG in private debt over the past decade has largely been driven by institutional investors. As well as seeking superior risk-adjusted returns with strong downside protection across credit cycles, these investors are driving meaningful changes in the private debt industry and requiring managers to significantly up their game on ESG.
The range of requirements has increased, and the conversation has broadened, but it is also true that investors want managers to go deeper, and ESG integration now needs to be considered in detail at the investment, portfolio and manager levels.
We believe that the future belongs to managers that listen to these requirements and improve and innovate accordingly. Here we focus on those initiatives that can help to address institutional investor requirements in private debt, by adopting a thoughtful approach to responsible investment.
Limitations in private debt
It is widely acknowledged that managers in private debt have more limited options for driving change on ESG than traditional private equity investors. In the absence of board seats and ownership interests, there are fewer levers for influencing company behaviour and decision-making.
These limitations must be put in the context of the developments in private markets more broadly, with private equity continuing to dominate the volume of private capital raised, despite the steady increase in private debt AUM over the past decade.
Like other private debt managers that work closely alongside leading sponsors, CORDET is well positioned to assess and learn from the responsible investment initiatives promoted by private equity managers and adapt some of these approaches that are now considered mainstream, such as enhanced negative screening and ongoing monitoring. In many ways, the limitations faced by the private debt industry in driving change does serve to elevate the role of responsible investments for lenders, as they must do more at the outset and be more specific and targeted in their approach.
Whilst limited in our ability to force change, CORDET believes that lenders have an important role in their ability to influence ESG. This becomes particularly important when private debt investors work with non-sponsor-owned companies and financial sponsors who are less advanced on ESG matters. CORDET’s main influence in the monitoring period of an investment is through our annual ESG questionnaire and via active engagement with management teams to raise awareness of the most material ESG topics for each company that we invest in.
The ESG questionnaire allows for constructive discussions with management teams and allows us to voice our and our LPs’ main ESG topics of interest to influence these areas. This further allows us to provide both a snapshot in time of the “ESG health” of our investment portfolio and importantly is also a framework for measuring progress. When looking at progress, we look at both the company specific data as well as the aggregate progress of the portfolio. This provides our institutional investors with additional information in assessing their ESG risk exposure and progress for their investment portfolio with CORDET.
It is widely accepted that integrating ESG considerations into investing decisions impacts long-term value creation and financial performance. In a world of increasing ESG investor scrutiny, managers can find themselves holding stranded assets. Equally, a commitment where possible to influencing companies in the private debt portfolio to ensure they operate in accordance with socially responsible business standards is also paramount, in the same way as it is also important for any manager to demonstrate its own ongoing commitment to operating in a responsible manner.
By assessing the ESG requirements for integration at the investment, portfolio and manager levels, private debt investors can dive deeper into the issues encountered at each of these levels and adjust practices accordingly.
A good example of this is the bottom-up analysis that can be used at the investment level. In addition to enhanced negative screening criteria, the exclusion of businesses that receive a negative overall score following assessment using a focused and considered ESG scoring methodology is becoming increasingly important.
Any scoring tool needs to allow for a structured assessment of ESG risks and opportunities, and ultimately this is something that needs to be discussed and agreed across the full investment team to ensure it is representative of everyone’s main concerns and values. This allows for a more detailed and quantitative assessment providing greater granularity on ESG risks.
CORDET recognises that going beyond the traditional negative screening criteria, and beyond the UN PRI exclusion criteria, is simply good risk management. For example, we would not invest in a company that is indirectly exposed to a high ESG risk category (eg, through its clients, such as a business engaged in marketing services for oil and gas services clients). Other examples include us declining to invest in companies that generate their majority of revenue from selling and promoting the consumption of alcohol, selling and profiting from single-use plastics.
A standardised scorecard method for identifying and quantifying particular ESG risks not only supports our due diligence process, but it also allows us to identify investment opportunities with positive ESG characteristics that we believe improve our portfolio’s risk-reward dynamic.
An example of this is our recent investment in a leading Swedish biosolids waste management company, which allows for a double-positive ESG implementation: it removes the need for farmers to purchase fossil-fuel derived fertiliser by re-using existing nutrients that otherwise would have been discarded.
The business benefits from several structural ESG trends such as increasing demand for sustainable agriculture and circular waste solutions, thereby supporting wastewater companies with waste management and providing renewable resources to farmers. By returning nutrients and soil substances to modern plant cultivation, this business helps both the economy and the wider environment in creating a circular process focused on sustainability for the long term.
The industry is also seeing increased use of third-party ratings systems as part of scoring and methodology, but it is also important to avoid over-complicating any part of the process at the risk making it unwieldly or potentially redundant. While institutional investors want to see a variety of tools considered as part of a detailed action plan for responsible investment, by focusing on taking meaningful steps and adopting a more targeted approach, managers can more clearly demonstrate and articulate what is being done and what remains to be achieved.
Given the major lack of data in the smaller mid-market (and private markets in general), and the fact that smaller mid-market companies do not have the same resources as mid-sized or larger businesses to enable extensive ESG consulting efforts, it is all the more important to focus on quality. CORDET strives to be a patient capital partner that both understands the businesses in which it invests and focuses on tracking the development of material ESG indicators for portfolio companies to drive qualitative change.
This approach allows managers to avoid getting stuck in the trap of “not having the data” or “not having direct control like a PE firm”. While innovations and financial incentives such as ESG margin ratchets can be useful tools to drive change and promote certain themes, we believe the priority should be for managers to look at what they do as a key stakeholder by credit selection and focus more broadly on raising awareness of ESG in everything from the importance of good governance structures and employee engagement surveys to D&I strategy.
ESG in action
As noted above, the formulation of an overarching ESG policy is a fundamental, if relatively rudimentary, step towards adopting a thoughtful approach to responsible investment.
Institutional investors want to see how these policies are applied in practice in the real world in order to ensure that they are being actively considered and implemented. They want to see the progress that has been made with fulfilling the standards and tests espoused by these policies. They want to see ESG in action.
There are a number of global responsible investment initiatives that encourage managers to report on a range of topics. The two that appear to have gained most traction in the private debt space are the UN PRI and Task Force on Climate-Related Financial Disclosures.
However, there are many others out there. These frameworks have evolved over the years and in particular the latest UN PRI reporting assessment has built out a new “private debt” sub-section alongside “fixed income”, providing additional guidance and scrutiny in relation to the private debt space.
However, these industry frameworks can only go so far and institutional investors want to hear more about the specific experiences and initiatives undertaken by managers. The production of an annual responsible investment report, now integrated into CORDET’s ESG framework following publication of our first responsible investment report in 2020, is a positive way to showcase the developments made by a particular manager and tell the story in a tailored, focused and personalised way. It is also a way of speaking directly to investors on issues that concern them most, enabling managers to cater for specific investor requirements and preferences.
Such initiatives also promote broader transparency and accountability by enabling managers to communicate more widely with other stakeholders. Investor reporting is typically private. However, by making a responsible investment report public it is possible to stimulate broader readership and feedback from across the industry and ultimately make a larger contribution to the discussion. Alongside reporting on progress, steps can be taken to set goals and ambitions for the future which can then be referenced and benchmarked.
Promoting engagement with investors
Above all, institutional investors want to see active engagement and participation on ESG topics. Many investors now utilise their own ESG due diligence questionnaires tailored to their own approaches and requirements. Detailed responses, and providing thoughtful commentary and analysis, go a long way towards helping investors to fulfil their own requirements and demonstrating what it means to be in partnership with investors.
Rather than putting the answers and responses to one side once completed, we believe it is important to be as collaborative and proactive with investors as possible, for example by participating in follow-up calls and promoting continuous dialogue. Only by adopting a thoughtful and transparent approach to responsible investment, can managers go one step further towards addressing institutional investor requirements.
Christian Ovesen, partner, John Sealy, chief credit officer, and Henrik Wikerman, investment professional, are all members of CORDET’s ESG working group.