Once upon a time, environmental, social and governance concerns appeared solely on the agenda of equity owners in listed companies. It was, after all, the shareholders who had the power to vote at company meetings and sell out if things did not go their way.
It was presumed that even owners of public debt had to go along with the corporate programme as they had very little leverage to apply.
Today, however, things have swung 180 degrees, with investors of all stripes pressing their ESG concerns to fixed income fund managers and ensuring the rising tide of interest in private debt is part of the push towards sustainability too. For example, in February, the New York State Common Retirement Fund allocated $800 million to sustainable fixed-income strategies in a mandate that included private credit.
Chinese financial services conglomerate Ping An has created a tool to combine artificial intelligence with ESG to analyse these factors across its investment platform. Incorporating China’s second-largest life insurer, private debt is a growing part of its portfolio.
“It is sometimes argued that debt investors can’t exert any influence because they aren’t voting shareholders: we disagree,” says Stephen O’Neill, head of private markets and investment proposition at the UK’s multi-employer pension scheme, National Employment Savings Trust (Nest). “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, whether with regards to financial prudence or ESG behaviours.”
Nest is one of the first defined contribution pension schemes to allocate to private debt and, with a firm conviction towards sustainability, picks fund managers that “have just as much analysis and understanding of ESG risk factors as their counterparts in the equity space”, says O’Neill.
Follow the leader
Where giants lead, others follow, so private debt managers concerned solely with risk, returns and illiquidity need to get with the programme. The days of leaving ESG to other sectors is over.
According to investment consultant Mercer’s annual asset allocation survey, 89 percent of pension funds say they consider ESG risks when constructing their portfolios. This was a sharp rise from 55 percent in 2019, and more than double the 40 percent who said so in 2018. The same survey shows an increase in the percentage of pensions allocating to private debt from 11 percent to 16 percent.
David Scopelliti, global head of private credit at Mercer, says investors were increasingly aware of the downside risk ESG factors can bring to a security. He added that effective managers could integrate these considerations into their credit and risk framework alongside purely financial metrics.
“We actually turn down around 20 percent of all loans we see due to concerns around ESG”
“Investment strategy can also influence the scope for ESG integration,” says Scopelliti. “For example, longer-dated private credit strategies will evaluate companies based on their potential to perform throughout the holding period.”
This increases the chances of ESG factors becoming relevant within the investment horizon – and consequently should be part of the analysis right now.
However, there are a couple of wrinkles to be ironed out before ESG follows private debt into the mainstream.
“Private markets do not have standardised ESG reporting and therefore ESG metrics tend to not be comparable,” says Jemima Atkins, assistant vice-president, infrastructure debt at Allianz Global Investors, which integrates ESG into its underwriting.
For investors that need all data to be automated and uniform across portfolios, this may be a challenge. “Specific key performance indicators can be identified for individual investments and should be considered on an isolated basis,” says Atkins. “Aggregating these key performance indicators on a portfolio basis is challenging given non-standardisation and can be misleading given many ESG risks are not capable of quantification.”
It seems the alluring feature of private credit is also a spanner in the works for applying ESG, but where there is a will – or investor demand – there is a way.
“Private credit is idiosyncratic in nature, be it corporate lending, real estate or infrastructure,” says Phil Dawes, head of sales UK & Ireland at BNP Paribas. “This provides investors with diversification but also presents a challenge when considering ESG characteristics and subsequently monitoring their performance.”
Options around the UN’s Sustainable Development Goals may be applicable for impact investments but are likely to be a stretch when just improving company behaviour on basic ESG elements.
“As with ESG in private credit overall, the monitoring and reporting of these metrics will evolve over time,” says Dawes.
But while uniform reporting develops, there is no excuse for a lack of analysis, according to keen investors.
For Patrick Marshall, head of private debt at Federated Hermes, ESG risk should be assessed like any other.
“Unless you can understand these risks, you won’t be able to understand how a company is run or know if you are being adequately remunerated for the risk you are taking on,” he says. “Nor will you be able to try and change any questionable behaviour by the company.”
Federated Hermes uses ESG as a risk management lens across its entire private credit portfolio.
“We actually turn down around 20 percent of all loans we see due to concerns around ESG,” says Marshall, “and we have seen around half of these go on to be problem loans for other managers during the recent crisis.”
Marshall believes the covid-19 crisis will be something of a gamechanger for the application of ESG factors to private debt, as it highlights the key failings in a company that only become more acute in times of economic stress.
Yet, Peter Arnold, global head of private assets sales at Schroders, thinks the transition may take a little while to bed in.
“Everyone wants ESG, but they don’t want it if they think the yield might be hit,” he says. “ESG funds are earning around 5 percent, with non-ESG funds earning 12 percent, so in the shorter term, ESG might take a back seat.”
This short-term thinking will not last long, however.
“ESG is going to be fully integrated into strategies in the longer term,” according to Arnold. “Investors will be able to choose whether to invest in a company or not based on its ESG criteria and as society is pushing more on these factors, there will be more companies that conform, therefore creating more inventory.”
It is not just society that can push the ESG agenda, of course. One of the perks of lending directly to a company is the influence an investor then holds.
“As direct lenders, working together and influencing decisions of companies is key for improving on ESG,” says Arnold.
Indeed, Marshall’s team at Federated Hermes once pressed a portfolio company to produce its plastic products using 50 percent recycled tyres. The move was so successful, it went on to be used in its advertising campaigns.
Marshall says the carrot – “If you do this, we will support you” – is more effective than the stick – “we will walk away” – on pushing for change as a private debt investor, and he is seeing a gradual virtuous circle forming in the sector.
“Removing the ESG risk adds to the overall value to the company, leaving it in better shape for all stakeholders and results in less risk for the investor,” he says. “That’s the ultimate fiduciary management.”