Everyone can agree that taking environmental, social and governance issues into account is now a greater priority for private debt fund managers than it has ever been in the past. But questions remain over exactly how seriously it’s taken and the best way to incorporate ESG into investment processes.

The first of these questions was addressed by a report published by TMF Group, the UK-based administrative services firm. It found that companies with poor ESG credentials were likely to fail lenders’ initial screening phase and few would make it as far as the conducting of due diligence. However, the report found that there are some exceptions where a company is deemed worthy of investment even if they have less than optimal ESG credentials.

There is also something of a disparity in attitudes between Europe and the US. While it’s clear that no US manager could overlook ESG – especially one hoping to raise capital from European LPs – the suspicion lurks that it’s not top of (or even near the top of?) the priority list. The TMF report does little to dispel this notion, quoting one US manager as follows: “Our LPs are starting to emphasise it more and more, and while we are incorporating it into our investment approach, I wouldn’t say we are primarily an ESG-driven firm.”

Experimental approaches

How to incorporate ESG into investment processes was pondered at our 2021 Virtual Forum in September. While the private debt asset class has been lauded for innovative incentivisation methods in relation to ESG, these approaches are still of the experimental variety. “We don’t have a regulatory or legislative framework we can point to,” said one large fund manager at the event. Methods used so far were described as “still very much in the laboratory”.

One of the biggest trends seen lately has been the emergence of sustainability-linked loans that measure the issuer against pre-determined ESG metrics, most typically in the form of margin ratchets. But one investor at the event asked what kind of ratchet was sufficiently material to encourage good behaviour: “Is it five or 10 basis points, or does it need to be more? And what KPIs do you use to guarantee that initiatives are actually being implemented?”

Few would doubt the willingness of private debt fund managers to play their part in a more sustainable future. Exactly how this is best achieved will remain a talking point for some time to come.