It was back in September 2021 that the “anti-ESG” movement was arguably born. Texas governor Greg Abbott signed Senate Bill 13, which was designed to protect the state’s energy industry from the shift towards decarbonisation of investment portfolios by funds and asset managers. The bill prohibited state investment entities from investing in companies that boycott the fossil fuel industry.
The ESG backlash soon gained ground. Since the Texas bill, 13 other US states have adopted similar measures. The roll call requires a deep breath: Arizona, Florida, Idaho, Indiana, Kentucky, Louisiana, Minnesota, North Dakota, Oklahoma, Pennsylvania, South Carolina, Utah and West Virginia. The movement has evolved in ways bound to make life difficult for any ESG-focused managers fundraising in those states. Last year, Florida and Indiana moved to prohibit investors in their states from backing investments or strategies based on ESG: the interests of fund beneficiaries would be the only consideration.
“European private debt has been at the forefront of ESG thinking and how it gets implemented,” says Andrew Bellis, head of private debt based in the New York office of Switzerland-headquartered Partners Group. “But there are quite different views in the US – or certainly in parts of the US – about ESG and whether it conflicts with the responsibilities of the manager to get the best returns for investors.
“In general when we speak to European LPs, there’s an acceptance of ESG. They typically have their own ESG framework and therefore expect managers to have frameworks as well. If I look at our direct lending business in Europe, a significant proportion of the loans have sustainability linkage. If I contrast that with the US it’s interesting because we’ve had discussions with some US investors that do have a positive ESG view – maybe a subsidiary of a global organisation – and they want to allocate in dollars but struggle to create something that works from the point of view of an ESG framework, because it doesn’t really exist in the US private debt market yet.”
Bellis believes the issues in the US are primarily to do with politics and reflect the polarisation that has become ingrained in numerous areas of discourse in the country. Tamara Close, founder and managing partner of Close Group Consulting, an ESG integration advisory firm based in Canada, agrees but also thinks investors and managers alike are refusing to dive down political rabbit holes and are instead inclined to view ESG as a crucial part of risk management.
“It seems that with a lot of things in the US you’re taking sides and so many issues are polarised that it wouldn’t surprise me if this [anti-ESG movement] continues,” says Close. “The fund managers we speak to in the US were very concerned about all this in the beginning. But what gives me a lot of comfort is that they’ve kept the same investment process but just changed the narrative back to risk management and away from political rhetoric. For instance, they may decide to stop talking about exclusions [like fossil fuels] which they wouldn’t have invested in anyway, because they didn’t make sense from a business risk point of view.”
In Close’s view, ESG has most relevance to credit providers as a refinancing risk. “One of the big reasons to be focused on ESG is because not taking it seriously can make it significantly harder to get financing. It’s pretty critical, especially in Europe,” she says.
Bellis agrees on the importance of assessing refinancing risk. “We might look at a business and decide technically we could lend to it, but as part of due diligence there could be various ESG factors dissuading us. We take the view that in an environment where it’s hard to refinance you certainly don’t want an ESG component in a company that you lend to that makes things significantly harder.”
One thing for sure is that ESG is now firmly centre stage for lenders. It may sound like a statement of the obvious today, but you don’t have to look back too far to a time when lenders were seen as backseat drivers on such issues, while the providers of equity had their hands on the steering wheel.
“It seems that with a lot of things in the US you’re taking sides and so many issues are polarised that it wouldn’t surprise me if this [anti-ESG movement] continues”
Close Group Consulting
“The role lenders have in driving ESG is absolutely huge,” says a market source.
“With equity holders, there’s a broad mix and, in times like these, their motivation on ESG issues may be determined by how much residual value there is. In terms of driving change, I think much of it will come down to the lenders.”
While there has been much interest generated by the incorporation of sustainability targets into loans, some say it obscures what is really the biggest and most important advance – namely, ESG becoming a priority in due diligence processes. “We’re seeing a lot more GPs on the private credit side doing ESG due diligence, whether they’re doing it internally or outsourcing it to a third party. Some will do all the other due diligence and then they’ll do the ESG at the end in response to LP requests but increasingly we’re seeing ESG featuring across the whole due diligence timeline,” says Close.
Close also believes that ESG due diligence has a bigger role to play as private equity sponsors seek to limit further financial support only to those portfolio companies that they think will be the most robust as market conditions become more challenging. “They’re going to support those companies they believe are the most resilient and will have the greatest value at exit and it begs the question of what makes a company resilient – and a lot of that is how they’re handling ESG issues,” she says.
Regulators in Europe’s driving seat
Watchdogs are credited with making Europe the epicentre of ESG adoption
It was regulators who were the first to make sure that ESG was on the agenda of private markets investors in Europe. The importance of ESG in the region is captured by Tamara Close of Close Group Consulting: “As a GP you will not get one dollar allocated to you from a European LP if you are not looking at ESG and climate – and that’s true across the board.”
On North America, she adds: “I would say that push from the regulators hasn’t been there, but it’s coming. They’ve been waiting to see whether the industry can sort things out before putting anything firmly in place but there are things coming down the line such as ESG audits of managers.”
Regardless of regulation, there is a feeling that investors everywhere are looking at ESG from a risk perspective and how the risk is likely to impact returns five or ten years down the line. Many managers are hiring internal and external ESG experts to weight up the issues and awareness of the importance of ESG is growing all the time.
Andrew Bellis of Partners Group says European direct lenders can struggle to raise capital from the US because things like ESG frameworks and ratchet mechanisms tend to be tailored to European businesses. It would be wrong to think this is a turn off for all US investors though: some states, such as California (home to some of the world’s biggest LPs), are strongly in favour of Europe’s approach to ESG.
Lack of clarity
One of the biggest challenges for lenders and investors is how to measure a company’s performance against ESG metrics. “It’s important to ensure there’s an audit process for measurements,” says Bellis. “A year or two ago there was a lot of uncertainty around who was measuring and how. Firms arguably had the ability to get a slightly lower cost of financing with a lack of clarity over whether results had been achieved.”
Now, given the demand for a diminishing supply of debt financing, lenders are finding themselves operating in a more favourable environment. “The power is in lenders’ hands, and they can more clearly articulate and define their key performance indicators and how they will be checked,” Bellis notes.
Close says: “It’s definitely challenging in private markets with mid-market companies to get all the data that you need to be able to calculate performance and to be able to monitor sustainability targets.”
She adds that her firm oversees pre-investment due diligence and scores all the issues seen as major risks. It then reassesses those scores throughout the holding period of the investment. “It’s a way of bringing some transparency to the LP, GP and company to show how they’re performing on these issues even if you don’t have the perfect quantitative metrics,” she adds.
In terms of making the hitting of ESG targets a contractual matter, the method that has been universally applied to date is the margin ratchet. This normally sees the interest paid on the loan reduce when targets are hit and increase when they are missed.
According to information services provider Reorg, European leveraged loans with ESG features became increasingly prevalent in 2022 with 50 percent including sustainability-linked features. This continues the upward trajectory noted in 2021, when 44 percent of European leveraged loans included these features. Despite the slowdown of the European primary market due to the Russian invasion of Ukraine and rising interest rates, ESG remains at the forefront of developments in the European leveraged loan market.
Advantage to the banks
Nick Williams, a partner in the financial industry group and co-head of the private credit group at law firm Reed Smith, thinks the margin ratchet is one area where the much-maligned banks have the advantage over private debt funds: “I think it’s more embedded and higher up the agenda within the large clearing banks because they have the dedicated resource to really get their arms around what ESG means,” he says.
“Time spent in diligence and reporting is so important, as well as the credibility of the underlying data, because otherwise you’re on the greenwashing tightrope that is not worth being on. You’re better off not considering ESG as a factor in your lending unless you’re doing it properly because you’re going to open yourselves up to reputation risk, legal risk and financial risk and that is where the banks are ahead of the curve on the debt funds.”
Williams says that while it “feels right” that a borrower should receive a financial reward for performing well against its metrics, it’s not as easy to reconcile a lender benefitting from the increased margin that accompanies underperformance. As a possibly more palatable solution, he points to a real-life example of a sustainability-linked loan involving three lending banks where financial penalties for missed KPIs would go into a collection for charitable causes to be paid over the following 18 months. It felt, he says, like a neat solution.
One of the major question marks over the margin ratchet has been over whether it makes a material difference. Bellis recognises the concerns. “Is it punitive? No, it’s not,” he says. “Is it massively beneficial to the business? No, I don’t think it is and I would say, unfortunately, that’s the negative side of ratchets. Having said that, I still think from a lender perspective they do focus the mind of the borrower in terms of what’s important for lenders so while plus or minus five basis points for these things doesn’t seem like a lot, it can be quite useful.”
Close agrees that ratchets have had some bad press either because they are too low economically to make the company do anything meaningful, the targets are too easy to hit so there’s no real change to the company or the targets are on immaterial issues so there’s no risk or impact on the fund.
“It takes time and it’s expensive to do and so you can see how GPs will maybe not want to go through that process,” says Close, “but I think LPs are getting much more aware of this and they’re questioning these ratchets a lot more. They really want to make sure if borrowers are getting up to 10 basis points of savings that it’s having an impact. I think we’ll see a reduction in the number of ratchets, but I think we’ll see much more authentic ratchets”.
To come back to a point made earlier, the margin ratchet should only ever be seen as a useful supporting tool once thorough credit underwriting has established that the lending opportunity is a compelling one.
As Bellis puts it: “We don’t lend to a bad company because we’re able to get a slightly tighter covenant. If it’s a fundamentally bad business we don’t want to lend to it. I think the same on the ESG side, we don’t want to lend to a company with an ESG issue because we get a slightly better ratchet, we just don’t want to lend to it.”
Apollo launches integration project
Lenders are working together to gather better data
Apollo Global Management has been an active participant in the push towards better ESG data collection, recently becoming the inaugural chair of the ESG Integrated Disclosure Project, an industry initiative bringing together lenders in the private credit and syndicated loan markets to improve transparency and accountability.
As part of Apollo’s own internal push, Michael Kashani was hired from Goldman Sachs – where he had been global head of ESG portfolio management in fixed income – as head of ESG Credit in October 2021. He has recently been involved in the firm’s publication of a white paper, The evolution of ESG credit at Apollo: from managing risks to seizing opportunities.
“What we noted in the white paper was that historically on the credit side, ESG integration has always been about risk mitigation. While that is still very important, we are also evaluating ESG credit from an opportunity lens, proactively thinking about how we can turn emerging risks into opportunities for Apollo and our investors,” Kashani tells PDI.
“We set out a framework that was a collaboration between our investment and ESG teams which was very important. We wanted that engagement across teams so each team approved the framework and also understood that they were the ones applying the ESG credit risk rating with the support of the ESG team.”
Kashani says the history of ESG in the private credit industry has been a bit of a black box. “Everyone has a rating and everyone says ‘trust us, it’s the right rating.’ From our standpoint, we are striving for transparency – around what our frameworks are, how they were originated, who applies them, how the process is supported, and what the coverage is. We also want to convey that we continue to build our capabilities in certain areas, but always in a way that is rooted in a fundamental investment thesis of value creation.”