Green light for ESG-focused debt funds

Private debt has been slower than private equity to prioritise sustainability issues, but investors are now making the case that taking them seriously will add value to GP offerings.

Private debt managers are increasingly focused on environmental, social and governance criteria (ESG) when assessing lending opportunities and wooing investors, and not just because LPs are placing more emphasis on it when picking GPs in the asset class.

While ESG policies have been slower to develop in the private debt space than in private equity, consultants say they are witnessing a surge in activity. As the range of investors targeting the asset class continues to grow, and competition increases among managers, ESG is becoming a hot topic.

James Stacey is a partner at global sustainability consultancy Environmental Resources Management, which employs 5,000 people worldwide across 160 offices. Stacey has previously worked in both banking and private equity and says: “We have seen a real swell in enquiries and engagements providing support to credit funds on their design of ESG management frameworks and the integration of ESG into existing due diligence procedures. This has really taken off in the last two years, in part driven by LPs and an expectation that there should be a management policy in place for both credit and equity funds.”

Private equity firms have been working towards sophisticated ESG policies for over a decade in response to investor demand, but the credit space is different. For a start, the level of control over investments is much less, and therefore risk management is the greater consideration.

Stacey describes ESG as more of a risk management exercise for credit funds, rather than being driven by ethics. He points to examples of infrastructure funds with highly-developed ESG policies and procedures, which break down the market into sub-sectors, and highlight ESG risks for each, providing a toolkit to alert members of the deal team to issues that could pose material concern.

“Firms are effectively creating frameworks for deal teams to ask the right questions and get the correct coverage of issues during due diligence,” says Stacey. “Then it is about having the correct loan conditions and key performance indicators in place to monitor material issues within the investment during the loan period.”

One thing upping the pace of ESG development in the private debt space is a transfer of learning within fund groups, taking what they are doing in private equity into their credit funds.

Room for improvement

Niels Bodenheim is senior director of private markets at consultancy bfinance, helping investors with their debt allocations. He agrees that credit managers in both the US and Europe have focused on their ESG policies in recent years, typically detailing for investors the considerations made during the investment process and the procedures involved, but there is still room for improvement.

He says LPs are getting much more interested: “The majority of our searches have an ESG focus today, and that can be as simple as sector exclusions. More and more investors are looking for specific exclusions, usually tobacco, weapons, cluster munitions. In the US there has been a big growth in the marijuana business, and that’s becoming institutionalised, so we are seeing requests to have that excluded as well.”

But while the LP focus on ESG has played a role in driving managers to up their game, many are taking a more proactive approach and consider taking a strong ESG position as an opportunity to differentiate themselves in a crowded fundraising market.

Bodenheim says: “What managers need to do is focus less on the market opportunity in fundraising, and more on their value-add proposition. If you have a strong ESG consideration in your process, it is worth marketing that as an opportunity. Hopefully people will start to view this as a strong point of differentiation in the coming years as competition hots up on the fundraising side.”

It is also true that the investor pool targeting private debt continues to diversify. Newer entrants to the asset class, such as UK local government pension schemes (LGPS), are making allocations but bring with them a heightened focus on ESG, using it as a factor to pick fund managers in the crowded space.

“We work a lot with LGPS investors in the UK,” says Bodenheim, “And every single one of those is asking about ESG in their investment process. Super funds in Australia will have the same concerns, as do some of the pension funds in Canada, who may be long-term investors into this space already.”

Other segments of the LP market that are particularly focused on ESG include public sector worker pension funds, church pools of capital, and certain sovereign wealth funds, like Norway.

Pressure

Stacey says he sees a portion of the LP community putting pressure on GPs, whether motivated by ethics, fiduciary duties and/or risk management reasons. Some GPs are simply acting to improve their policies in the run-up to fundraising processes because they know that there will be more detailed questions coming down the line.

“Another driver for GPs is genuine risk management,” says Stacey, “because they know that ESG issues could create a material credit risk or reputational risk, or both, to the entity and they want a formal process to address that. Most funds have something in place that is informal, to deal with these issues, but now is the time to professionalise these processes and formalise things.”

Finally, some managers see ESG as the route to better financial returns and are building frameworks that enable a focus on investments with this potential.

Stacey says: “It is about being able to say to your investors that you have identified a segment of the market where you believe that, by using an ESG filter to select your investments, you can get an edge in the market and deliver enhanced results. We are seeing this with property funds and in certain parts of the infrastructure market, where you can effectively have an ESG loan product that is structured to gain a competitive advantage.”

With so much consensus in the investment community around the need for more advanced ESG policies, private debt is the latest asset class to formalise its approach and appreciate the benefit of a more sophisticated pitch to investors.

Stacey concludes: “A private debt fund manager will want to be able to answer the question about how they are managing ESG risk in their portfolio, such that it doesn’t have a negative impact on financial returns. If you haven’t got a good answer to that, you might want to reflect on what you could or should be doing.”

WHY PE’S ESG GRIP IS TIGHTER


Alison Hampton, former head of responsible investment at Hg Capital and now head of responsible investment advisory firm Alma Verde Advisors, says control is the key issue

“The distinction between private equity and private debt in this area is the level of control you have got over what happens at a company. For private equity, poor ESG standards at the time of the investment can provide a great opportunity for value creation, and the level of ownership control means that you can require improvement, whereas when you’re lending your only influence is on the conditions you impose at the outset. From a debt perspective, the position is analogous to that of a lending bank, where all you can do is set out parameters, make a thorough assessment of ESG risk, and focus on diligence upfront.”