The introduction of the EU’s Sustainable Finance Disclosure Regulation in March accelerated an already hot topic up the agenda of credit managers in Europe. With US regulators likely to follow suit with their own ESG regulations, there are lessons that mid-market US debt managers can learn from their European peers.
“In many ways the US is at a significant advantage as the last mover on this,” says Kevin Bourne, head of sustainable finance at IHS Markit. “They can see what everybody else is doing with regulations and then take a view on what’s likely to be the most effective.
“The simple fact is that all public and private companies, and public and private financial institutions, are going to have to report these metrics globally within five years.”
He says one thing the European regulations do well is provide templates to allow for consistent disclosure of information. “Rather than having different fund managers all over Europe wondering how to display the data, the regulators have created a template for everyone to use,” says Bourne. “That’s very helpful for investors who can then do meaningful comparisons across firms.”
For managers, getting ESG data in good shape must be a priority.
“Things will move very fast when the US decides to put things in place,” says Flavia Micilotta, director ESG solutions, global fund services, with TMF Group. “For US fund managers looking at what’s happening in Europe, the lesson must be to start now to instil discipline and transparency around ESG reporting.
“Funds need to pay more attention to the governance side of things and how they market their products, making sure they are able to explain, for instance, how they embed ESG into different strategies and which metrics and KPIs they choose to focus on.
“Being able to explain how they approach this is fundamental because inevitably clients are going to become more intense with their demands and more interested in the way that products can be compared. Managers will need to be more knowledgeable and more accepting that this needs to be part of every conversation.”
Increasing interest from LPs
It is not just pressure from regulators driving the heightened need to engage in a meaningful ESG discussion, but also rapidly escalating interest from LPs.
Blackstone takes a global approach. Rita Mangalick, managing director and global head of ESG for Hedge Fund Solutions and Blackstone Credit, says: “LPs expect ESG to be considered as part of the investment process whether the fund is based in the US or Europe.
“However, European funds are typically more advanced as it relates to ESG – with more focus on the ‘E’ than other regions – as they generally have been considering ESG-related risks for a longer period of time. But we are seeing US funds coming up the curve quickly.
“We expect to see a continued and increased focus on ESG in the US by regulators and investors. Investor demand for ESG investment products remains high and ESG-focused funds continue to take a large share of inflows.”
“We expect to see a continued and increased focus on ESG in the US by regulators and investors. Investor demand for ESG investment products remains high and ESG-focused funds continue to take a large share of inflows”
Hamish Grant is deputy managing partner of Bridgepoint Credit, which last year completed the acquisition of EQT Credit to create an enlarged group with €7 billion under management.
“The ESG topic has come from nowhere in Europe five years ago to now being completely central to every aspect of investment activity,” he says. “It’s a key part of pricing, structuring, governance and strategy, and it’s key to screening investments, due diligence and then managing investments. We see it has also become a central item on investors’ due diligence agendas, with a key focus on GPs being highly specific and material in their approach.”
For now, that investor focus is concentrated among the European LPs, with US, Middle Eastern and APAC investors showing a little less interest. “That was noticeable,” says Grant. “For some European LPs, this is a true gating item now. If you don’t have a good answer to the ESG questions, they are just going to move on.”
Transparency, improvement and progress
No longer is it sufficient for a credit manager to avoid investing in sin industries or have a rudimentary set of ESG questions for prospective borrowers.
In Europe now, Grant says: “You see various levels of maturity among credit managers, from those overtly seeking to have influence over the direction of travel for the management team and shareholders, to those trying to truly assess the quality of how well the sponsors do that and filtering out opportunities where they don’t feel sufficient importance is put on that, and then those asking questions but taking little consideration of ESG in investment decisions. We want to be at the forefront, really influencing the direction of travel.”
Bridgepoint Credit is one of the firms leading the way on ESG margin ratchets on its loans – not only does it ask detailed questions about a borrower going in, but it also then identifies
areas for improvement, reports and tracks progress, and adjusts the margin on the loan accordingly.
“That has two benefits,” says Grant. “One is that we are incentivising the management team to do the right thing and not do the wrong thing. But the more powerful impact is the indirect one, which is that the ratchet gives you a right to information and a seat at the table.
“This gives us an entitlement to a better, quality dialogue on things like diversity and inclusion. We’re at the start of a new phase of much more active ESG engagement from credit funds.”
US funds can expect similar pressures soon. Howard Eisen, head of fund services for North America at TMF Group, says: “If you are a small or mid-market fund manager, not necessarily compelled to do anything immediately because you don’t have to worry about SFDR or any other non-US regulation, you should still be starting to figure out how you are going to extract accurate and compliant data when the US regime comes around.”
At law firm Travers Smith, partner Michael Raymond says: “The challenge for managers is that a lot of these firms have a lot of diverse credit products on the road and international, national and regional policymakers are generally pushing in the same direction but requiring different things, which increases complexity.”
Vanessa Battaglia, senior counsel at the law firm, adds: “There’s a lot going on in terms of defining the ESG standards and metrics that should apply to funds. We see more involvement from regulators on green bonds, for example, with the recent publication of the new European Green Bond Standard.
“Fund managers are ultimately seeking consistency across their investment portfolios. The expectation is that the ESG metrics used across various segments of the market will align, including in the derivatives, leveraged finance and fund finance space.”
Many guidelines are actually emanating from industry bodies, such as the Loan Market Association and the International Swaps and Derivatives Association, not just regulators.
Battaglia concludes: “The practical lesson is that this is not a legal or compliance issue. Obviously, most of the changes have been driven by new financial services regulation or ESG regulation, but if you’re looking for someone to help bring everyone together, the firms that are further up the curve are those that have engaged ESG professionals.
“The key is to marry ESG expertise with the compliance, legal and investment priorities to pull all those pieces of the jigsaw together and make them fit. It is firms with that approach, and embedded ESG resources, that are able to handle this in a coordinated
While EU regulation is leading the charge, ESG is moving up the agenda for all credit funds globally, and those acting now will reap competitive advantage.
How SFDR is changing the game
The EU’s sustainable finance and climate change agenda comprises three pillars: the Taxonomy Regulation, which sets out a framework of definitions to help investors assess whether activities really are sustainable; the Sustainable Finance Disclosure Regulation; and the Low Carbon Benchmarks Regulation.
The Taxonomy Regulation will not now apply until 2022 at the earliest, making the SFDR, which came into force on 10 March 2021, the most pressing. The SFDR requires all investment fund managers to disclose, for all the funds they manage, how sustainability risks are integrated into their investment decisions and the likely impact of those risks on returns. There are additional requirements for funds that promote environmental or social characteristics or have a sustainable investment objective.
“Firms are going to have to think about making sure they are making the necessary disclosures at firm level, product level, and for ESG-specific products,” John Verwey, a partner in the private funds group at Proskauer tells Private Debt Investor.