Debt investors can go beyond due diligence in ESG matters

As debt firms take a more proactive role in ESG issues facing portfolio companies, one expert highlights their potential for an ongoing dialogue with management teams.

Debt investors can engage with the management of portfolio companies about sustainability concerns well beyond their initial pre-investment due diligence, according to the founder of Close Group Consulting, an advisory firm that brings ESG expertise to the capital markets.

CGC describes one of its central goals as helping “investment managers … identify the strategic relevance of ESG integration across their investment funds”, working with them on “risk mitigation, value creation and impact objectives”.

PDI asked founder and managing partner Tamara Close about electric vehicle manufacturing as an investment, and the respective strengths of debt versus equity investors in that space.

Close, who published a thesis about volatility swaps in currency risk management in pursuit of her MSc Finance, acknowledged that “investors will always face a trade off between those ESG issues you are comfortable being exposed to from a risk return standpoint and those you are not”.

Debt investors in particular, she said, have to focus on pre-investment due diligence because in contrast to equity investors, they are not exposed to upside re-valuations. So they are committed to a “thorough ESG due diligence on the credit worthiness of the issuer as well as the actual debt issue (maturity, covenants, etc.)”. But that is not the only arrow in their risk management quiver.

One way in which lenders can mitigate their risk – a way not applicable to holders of equity – is through the management of duration. For example, an EV manufacturer may have important assets along shorelines, and as a result it may have a high exposure of risk to prospective seal level rises. But the onset of that risk may take some time, and it can be managed by the use of shorter-term loans.

Debt investors, as well as equity investors, can also engage with management about “relocat[ing] their assets or put adaptation measures in place”, Close said. Issuers are increasingly willing to engage in such dialogue. Portfolio companies want a good long-term relationship with their lenders, and for that purpose they can prove attentive to lender concerns.

Though due diligence is intended to avoid surprises, there is always the possibility of an “unforeseen or black swan event” creating an ESG controversy after the loan has closed. These controversies may impact the value of the equity without affecting the ability of the issuer to make payments on its debt.

Even in such a case, though, lenders share with equity investors reputational risk, Close cautioned. Sometimes private debt and private equity GPs will engage management in tandem on ESG issues, in much the same way bond and stock owners can work together with public companies.

CGC doesn’t work solely with investment funds. It also consults on the corporate side, helping the managers of operational companies to “identify and assess material ESG issues, identify the link to financial performance and recommend initiatives”, as its website says.

Given her experience working with such companies, Close said that many managements now understand “that improving their ESG credentials will allow them to get better financing terms the next time they need to raise capital”.

In a related matter, MSCI has released a new year’s report on “ESG and climate trends to watch for 2023”. Among much else, the report asks whether the “honeymoon [is] over for green bonds?” It offers no yes or no answer to that question, but does caution that continued growth for the green bond market will depend on the development of credible standards issued by third parties, rather than self-labelling by issuers.

It is at least concerning, the report says, that through 2021 and the first three quarters of 2022, 19 percent of the investment-grade self-labelled green bonds tracked by MSCI ESG Research failed to meet MSCI’s green bond and green loan assessment methodology.