Debt funds are taking control

Just how much influence do debt funds have over the environmental, social and governance policies of their borrowers? More than you might imagine, says Stephen O’Neill, head of private markets at Nest, the UK’s largest multi-employer defined contribution pension provider.

Nest announced in July 2020 that it would invest £5.5 billion ($7.3 billion; €6.1 billion) in “climate aware” strategies, with private debt funds among its favoured investments.

“It is sometimes argued that debt investors can’t exert any influence because they aren’t voting shareholders: we disagree,” says O’Neil. “An off-market lender has a lot of power – often private lending involves follow-on loans, and provisions for the lender to temporarily relax the terms of the loan. These can be withheld if the borrower isn’t doing what is expected of it.”

There’s also what Hamish Grant, deputy managing partner at Bridgepoint Credit, part of Bridgepoint, owner of PEI Media, calls the “relationship influence”: “We are not simply making a single loan for three, four or five years and then getting our money back – we are often either having to waive or amend minor terms or make follow-on loans. All of those discussions are points of influence.”

“It is sometimes argued that debt investors can’t exert any influence because they aren’t voting shareholders: we disagree”

Stephen O’Neill

For a long time, the focus was purely on negative screening in the private debt industry, says Allison Spector, director of sustainability at Nuveen, but that gradually shifted – first in Europe and then in the US – to ESG practices focused on qualitative due diligence in order to manage downside risk. “What has arguably had the most impact on private credit ESG practices is actually the deepening of ESG integration among private equity sponsors. The result has been a more data driven, quantitative approach to ESG in private credit,” says Spector.

And that has put due diligence at the heart of ESG strategies among private debt managers: “The most meaningful way to incorporate ESG factors as a lender is through the credit selection process; investing with an ESG mindset requires more stringent due diligence and the need to ask the right questions,” says Theresa Shutt, chief investment officer at Fiera Capital.

Covid has upended assumptions

The pandemic has brought ESG issues to the fore. “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,” argues Sonia Rocher, managing director in BlackRock’s European private credit group.

“The fundamental elements of ESG investing are the basic fundamental investment principles that we always look at”

Joe Moroney

“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.”

Coralie De Maesschalck, head of portfolio and ESG at Kartesia, agrees: “Covid has changed the way ESG is viewed by investors and managers, highlighting real vulnerabilities and social inequalities,” she says. “We expect investors and fund managers to prioritise investing with a conscience – we have added new questions to our questionnaire, for example, including around the ability of employers to offer flexible shifts for those unable to work from home.”

The move comes amid pressure from investors. “LPs are quite rightly sensitive to even minor negative exposures and will have certain sectors they simply don’t want to be associated with,” says Bridgepoint Credit managing director Alex Hökfelt. “That’s why you have to be innovative and try new things, as we have done with our framework. LPs are continuously challenging us to focus on ESG and we welcome that challenge.”

Impact is the new buzzword

Apollo’s co-head of global corporate credit, Joe Moroney, argues none of this is really new. “I’ve been working in high yield credit markets for 27 years and we have been doing ESG all that time – we just didn’t call it that,” he says. “The fundamental elements of ESG investing are the fundamental investment principles that we always look at. Now, we have to shine a more specific light on it and break it out for investors to show how we are explicitly thinking about ESG on every deal.”

The latest addition to the lexicon is impact investing, with fund managers increasingly using the term “impact” to describe the positive results of their ESG initiatives. It’s easy to be sceptical of new buzzwords, but there’s a sense that the movement might be more significant.

In Africa, for example, debt facilities have a major role to play in addressing social and financial inequalities. Amid covid-19 economic impacts, some firms concluded debt financing was the best way to support embattled SMEs. Vital Capital, an impact fund manager, set up a new facility to provide affordable credit to businesses providing essential services. Francisco Machado, Vital Capital’s VP of investments, says: “We launched this as an emergency facility, but we believe there is an opportunity for this segment to grow further.”