This article is sponsored by Fiera Private Debt
What proactive steps can debt investors take during the credit selection process to achieve environmental, social and governance objectives?
Theresa Shutt: In the past, socially responsible investing meant simply having exclusion lists such as no tobacco or gambling and avoiding the ‘vice industries’. Now, there are more proactive ways for debt investors to achieve ESG objectives.
The most meaningful way to incorporate ESG factors as a lender is through the credit selection process; investing with an ESG mindset requires more stringent due diligence and the need to ask the right questions. Most importantly, a manager must be willing to walk away if the investment does not meet their ESG criteria. At Fiera, we will not invest in companies where we perceive weak governance, social issues or environmental risks.
While we have always focused on robust governance and strong environmental and social practices as part of the underwriting process, we have now formalised those criteria and have been a UN PRI signatory since 2009. These new criteria allow us to dive deeper into an additional level of analysis to look at risks that cannot easily be measured by financial metrics.
This is particularly important for debt investors because for us there is no upside, we are entirely focused on downside risk. It is important to identify the non-quantifiable risks that have the potential to impact the loan quality.
Given a lender’s limited ability to influence management decisions, what steps can be taken during the hold period to manage ESG risk?
Paul Colatrella: We do have covenants and protections so that we can make sure decisions are made with regard to anything that might be an issue for us on ESG. We are limited in our ability to influence borrowers but we make sure protections are there and that all stakeholders are aware of any issues, which means being transparent to investors.
TS: The best way we can exert influence during the hold period is to structure the right covenants at the outset. We take a very customised approach to every deal and typically hold the debt for the life of the loan, which can be as long as 25 years. That encourages a stronger working relationship with the management team and gives us more leverage at the beginning to negotiate covenants. We may include loan terms that dictate the use of proceeds or set out compliance with environmental protections or safety laws. We might also have covenants preventing management from materially changing the business strategy which helps us maintain influence.
What are the added benefits of a sophisticated ESG approach to credit selection?
PC: Ultimately, we get stronger borrowers. As a debt investor, the priority is to identify anything that could materially impact the credit quality, and ESG is about unquantifiable risks that have the potential to make an impact down the line. It is not just about avoiding credit risks, but also the headline reputational risks of being associated with a company that gets itself into trouble.
“ESG is about unquantifiable risks that have the potential to make an impact down the line”
It should be a virtuous circle; if you’re investing with a strong ESG mindset, you will get better borrowers and better returns. It is relatively easy to know how to bypass environmental risks – you go with renewables over coal, for example. So, the ‘E’ in ESG is relatively easy, but the ‘S’ and the ‘G’ come down to the character of the business and its management. We are looking for management teams and sponsors with good reputations, with diverse representation, and making sure boards of directors are properly formed.
Where do you see opportunities to invest responsibly in infrastructure debt, and what kinds of credit selection challenges do you come across?
PC: The easy opportunity is in renewables and green energy. From a pollution perspective, it is very easy to quantify the benefits of those projects, in terms of tonnes and particles of CO² and emissions.
One growing sector is renewable natural gas, which can help reduce methane emissions and solve environmental waste issues as the methane is derived from waste that might otherwise contaminate ground water. We also anticipate increased opportunities to provide financing for distributed solar generation projects.
Globally, those technologies have become much more efficient, especially when combined with battery storage, which is getting better and better in its ability to compete with the most critical advantage of fossil fuels, which is reliability of supply.
The challenges come because we are just not quite there yet. We still get the majority of our power from fossil fuels. We don’t want the perfect to be the enemy of the good, so there is still a role for natural gas to play in replacing coal, for example, because it is cleaner and safer, until the build-out of wind and solar technologies is sufficient to take its place, which could take decades.
How do you see your approach to ESG developing, and how do you think the conversation will evolve in private debt?
TS: For both corporate and infrastructure debt, ESG metrics will become increasingly mandated by investors such that companies with good ESG practices will become preferred investments. Due to the higher intrinsic quality of those businesses, they will also outperform. There is now good data showing that prudent ESG underwriting provides better returns by preventing both financial and reputational losses.
Over the last six months, many borrowers faced challenges related to the pandemic, and the companies which outperformed were those that managed the ‘S’, focusing heavily on their staff and their wellbeing and ensuring strong engagement to promote productivity.
Good governance and good social practices have proven critical in 2020 and going forward it will become clear that this is not about buzzwords, but about credible financial returns. Funds that perform well on ESG will attract more capital from investors which will generate more opportunities to invest in ESG focused companies, leading to better outcomes overall.
Can you give an example of one of your recent infrastructure debt deals, and explain how ESG criteria factored into your decision-making?
PC: We have financed numerous projects where wind and solar have replaced fossil fuels. Large portions of the Canadian and US power grid still rely on coal-fired generation and ageing nuclear fleets. In addition to natural gas-fired power plants, the most reliable and clean alternative to these is wind and solar projects.
One example is a project financing by our infrastructure fund to build a windfarm at a remote mining town in Quebec, which allowed over 2.2 million litres of diesel fuel generation to be replaced, with major local pollution and carbon emission improvements.