Impact investing: Five things for debt funds to consider

This article is sponsored by Kartesia

In the world of private debt, impact investing funds are likely to grow fast. A lender might not seem likely to have sufficient influence on a portfolio company to make a positive social and environmental impact. Yet, at the small and medium-size enterprise end of the lending market, a carefully conceived approach implemented over time can make a difference.

The key tool at the lender’s disposal is the cost of a loan. A meaningful discount on the interest margin is an effective incentive for meaningful social and environmental improvements. What’s more, if the lender is responsible for a sizeable amount of a company’s borrowings – as may be the case with an SME – then the incentive is still greater.

But only a material discount matched by challenging targets for the sector and company and an ongoing support will make a genuine impact.

Judging by the intensifying interest in sustainable investing, the success of sustainability-linked loans – or SLLs – suggests that private debt loans will also grow. Over the four years to 2020, global sustainable debt issuance as a whole rose by approximately 45 percent to $732 billion, according to Bloomberg NEF. While SLLs are a small sub-set of sustainable debt – which the more established green bonds are the largest component of – they have grown from virtually nothing in 2017 to $120 billion in 2020.

This paper highlights the five considerations that we believe are essential for establishing a model for creating impact through private debt alongside delivering a financial return.

1 Lead by example to engage

As private debt investors are not owners of the company, unlike private equity investors, it has historically been more challenging for them to compel a company to take a specific course of action. For that reason, an asset manager running a private debt impact strategy must lead by example.

Examples at Kartesia include our Kartesia for Women initiative aimed to inspire women to join the private debt industry, or Kartesia being carbon-neutral since 2018.

Turning to Kartesia portfolio companies, Kartesia has also made clear in its sustainability policy that it aims to use its influence as an investor – via board seats, monthly and/or quarterly meetings with management and/or shareholders – to promote a commitment in its portfolio companies. Kartesia always aims to be the sole lender and when this is not possible assumes the majority position and controls the negotiations on legal documents for the transaction. As a result, Kartesia will maintain an open and ongoing dialogue with management by organising quarterly meetings on their ESG action plans and, where possible, appointing an independent ESG-focused director to the board.

2 Generating a genuine positive impact

Asset managers must justify their claims to be investing sustainably. There is justifiable scepticism that in some cases there is more marketing spin than substance. As a first step, the incentives and mechanisms in a private debt impact fund must be sufficient to fulfil the broad definition of impact investing: to generate positive, measurable social and environmental impact, alongside financial return.

We believe that a structure that gives a company a discount of as much as 50 basis points on the loan margin in return for substantial social or environmental improvements is the key. All too often, public market SSLs offer far lower discounts of 5-15 basis points as incentives for actions that make little difference.

With a long holding period of typically four years, a private debt fund can influence real change at a company. It can request a seat on the board to enshrine its part in ESG matters or negotiate monthly meetings with either management or the company sponsor (a private equity fund typically).

Starting with due diligence, the investment process must embed ESG analysis from the outset to show where ESG improvements might be made. The scope of analysis of the ESG due diligence will be adapted to the company’s activity, location and size. The typical criteria to be analysed in the due diligence are the following topics:

• Activity exclusions and norms-based analysis.
• Impact of products and services on sustainable development goals: both positive and negative impacts will be identified and, if possible, quantified (share of the revenues linked to these impacts).
• Impact of operations on the environment: environmental policy, energy consumption and carbon footprint, waste, water management, biodiversity, etc.

A thorough and robust ESG due diligence will allow the company to understand what risks and opportunities have been identified. An impact action plan is negotiated with the company, with targets such as reducing its carbon footprint by 20 percent or increasing diversity by a specific amount, with annual key performance indicators that once met trigger a ratchet mechanism, reducing the loan margin by a pre-agreed amount annually. As the private debt market generally lends to small or medium-sized companies, these ESG concepts may be new to them.

The framework for a private debt impact strategy should be twofold. First, the KPIs can relate to the most relevant of the UN’s 17 SDGs – for instance, for a manufacturing business this might be SDG 8: decent work and economic growth. Second, the EU’s Sustainable Finance Directive Regulation (SFDR) provides a legal framework for impact funds, which must reach the highest standard, Article 9. This framework also requires that asset managers disclose their policies regarding the ‘principal adverse impacts’ (PAIs) of their investment decisions – in other words, the negative impact their investments have on the environment and society. By bringing greater clarity to the market, the SFDR is reducing the potential for greenwashing.

3 Impact investing does not mean sacrificing financial return

There has been a long debate about whether investing for impact involves sacrificing investment returns. Research from the Global Impact Investors Network suggests otherwise. In its 2017 Evidence on Financial Performance of Impact Investments report, GIIN concluded that top-quartile funds “seeking market-rate returns perform at similar levels to peers in conventional markets”.

For a private debt impact strategy, providing a 50 basis points discount on a loan margin that might typically be in the region of 4 percent is significant for the underlying portfolio company but it is not a hugely material reduction in fund performance.

Furthermore, there is a growing consensus that ESG investing reduces a company’s risk by improving environmental and social performance. In the medium term, this logically improves the risk-adjusted return of a portfolio of loans. Anecdotally, there is evidence in Kartesia’s private equity portfolios of how good practice can improve a company’s trading performance.

The core characteristics of impact investing

The Global Impact Investing Network defines impact investments as those made with the intention to generate positive, measurable social and environmental impact, alongside a financial return. It defines an impact investment as having four characteristics.

Intentionality: Impact investments intentionally contribute to social and environmental solutions. This differentiates them from ESG investing, responsible investing and negative screening.

Additionality: Investments must achieve an outcome that would not have occurred otherwise.

Measurability: A hallmark of impact investing is the investor’s commitment to measure and report the social and environmental performance of underlying investments.

Market rate returns: Impact investments seek a financial return on capital that can range from below market to the risk-adjusted market rate. This distinguishes impact investment from philanthropy.

4 Reporting measurable KPIs

When it comes to reporting, the SFDR provides a list of KPIs for monitoring and reporting – some of them mandatory and others voluntary. These KPIs can be agreed with a portfolio company when a loan is being negotiated. Kartesia reviews those KPIs during the due diligence phase and monitors them on an annual basis.

Social KPIs might relate to the number of permanent employees, the number of female board directors or the number of accidents at work. Environmental KPIs would be likely to focus on a company’s carbon footprint or the intensity of its waste in areas such as water and energy.

Reporting those measurable KPIs is also a must. Since 2021, Kartesia included an ESG section and an SFDR section in all its investors’ quarterly reporting. In June 2021, the company also published its first annual Sustainability Report that is publicly available on its website.

5 Forming partnerships for expertise

Partnerships are key to impact investing, both to help asset managers to lead by example and to complement in-house expertise.

The company has been a signatory of the UN Principles for Responsible Investment since 2014. Kartesia follows the UN PRI guidelines as practical support to implement the six principles, and as guidance for incorporating ESG risks and opportunities into investment analysis and decision-making processes.

On the environmental side, Kartesia has been carbon-neutral since 2018, with the help of Carbonfootprint.com. Sustainalytics, the ESG rating agency, has performed an annual assessment of the investment portfolios’ carbon footprints since 2015.

Avoiding greenwashing

Looking forward, the EU’s Sustainable Finance Disclosure Regulation, which was implemented in March 2021, is likely to act as an accelerator for market growth. By categorising investment funds according to whether they invest sustainably, and to what degree, it is introducing much needed clarity into the market.

This transparency will provide assurance for Europe’s institutional investors, many of which now need to invest sustainably, and even for impact, for their own purposes.

There are also laws like France’s Pacte Law, introduced in 2019, requiring a company to declare its raison d’être through social and environmental objectives.

Indeed, there is a growing trend towards companies having a wider social purpose, in a clear break from the doctrine of the US Nobel prize winning economist Milton Friedman, which stated that a company’s sole responsibility was to shareholders, and was widely accepted in the 1970s and 1980s. For this reason, they need to find investment vehicles that are genuinely committed to making a positive impact.