Kartesia on why ESG is the essential ingredient

This article is sponsored by Kartesia

Could you describe private debt’s historic level of engagement with environmental, social and governance issues?

This asset class’s engagement with ESG principles has started relatively recently and is lagging behind the other asset classes. There is no consistent view on ESG best practice for debt funds.

The level of agreement about how to measure and implement ESG is much lower than it is in private equity, but this is not surprising as the asset class is smaller than private equity or real estate. Also, private debt players were for a long time viewed as ‘just assisting’ private equity players in market transactions. If you were seen as followers, there was less chance that you would be blamed if something happened, so the reputational risk was much lower. But this is changing, and private debt managers are now taking more operational responsibilities – by negotiating board seats, for example.

Is it true that private debt has been slower than private equity to embrace ESG? If so, why – and is this changing?

Yes, it has been a lot slower to embrace ESG. I used to work in private equity and it was very common there to see stringent requirements on responsible investment from LPs, and so that industry has a lot of tools and best practices at its disposal to integrate ESG criteria in the investment process.

When I joined Kartesia in 2015, private debt didn’t have its own tools and so you had to use those developed for the private equity space. There was also a lot less interest from LPs in ESG for private debt, and back in 2015 we might only receive one or two ESG questionnaires when raising a new fund. Today it is completely different, as most of the LPs will send a questionnaire including corporate social responsibility and ESG questions.

It’s a similar story with regard to best practice, where we would have to use UN Principles for Responsible Investment guidelines developed for private equity investors. It was not until 2019 that the UN PRI developed guidelines on responsible investing in private debt. I think this is because private debt has only recently been recognised as an asset class in its own right, and previously was always included in broader categories such as fixed income or alternative investments. The change, however, has been rapid among LPs, at least in both Europe and North America.

What are some of the most important ways in which managers can invest responsibly?

For us we focus on aligning our investment with our values. ESG means different things to different people but you always need to ensure your values are being factored into all investment decisions.

We have clear procedures and training. I will assist our deal team to ensure they integrate ESG into their process, but the deal team has to assess the ESG criteria for each company they look at themselves. We don’t want to have a separate team that deals with all the ESG aspects. It has to be integrated into the investment process.

“The crisis has revealed some of the inequalities that exist in society and given a renewed focus on issues around biodiversity losses, urbanisation or employees’ protection”

We also need to adapt our approach for our different types of investment as we invest in primary deals, secondary transactions and some collateralised loan obligations.

Primary deals are the simplest as we have more access to information and are able to conduct our own due diligence where we have a four-page ESG questionnaire for management teams. We can also put pressure on them to make any changes we require as part of the deal terms.

In secondaries, we are buying the debt from someone else on the market, and so we are relying on the due diligence of the sponsor to some extent and it’s a lot harder to change things and negotiate with the management team. For CLOs we analyse the ESG policy and process of the CLO manager and ensure it aligns with our own.

What does it mean to be a PRI signatory? Is it enough in itself, or do managers need to go beyond what PRI recommends?

At its most basic level it gives us an obligation to report annually on how our CSR and ESG efforts and procedures, and the UN PRI system also give us feedback from which to learn and develop. Signatories also receive a scoring from the UN PRI. This helps us to compare ourselves with our peers, but this also gives an indication to investors about our ESG performances. Today UN PRI has teeth as well, because you can be delisted if your progress in implementing the principles is not sufficient to meet basic criteria of being a signatory.

But aside from this there is always more you can do. For example, we have joined the UN PRI working group and have contributed to its report about responsible investing in private debt.

We have noted that investors are starting to pay attention to this. They don’t just want to know we are signed up to UN PRI but are now asking whether we have been involved in its projects and whether we have signed up to any similar agreements on ethnical investing. We found investors appreciate us getting deeply involved in working groups and helping to improve the way the industry looks at ESG.

Do you think the covid-19 outbreak will change the way ESG responsibilities are viewed?

Although many believe it is still too early to say what the impact will be, I think it has definitely changed the way ESG is viewed by both investors and asset managers. The crisis has revealed some of the inequalities that exist in society and given a renewed focus on issues around biodiversity losses, urbanisation or employees’ protection. Investors and fund managers will prioritise investing with their conscience. They will care about themes such as employees’ rights or consumer protections. When the crisis hit, the first thing we asked our portfolio companies was what they were doing to protect their employees.

I expect more fund managers and investors to focus on ESG considerations after covid-19, with demand for greater corporate transparency and stakeholder accountability.

It’s also notable that ESG funds are performing better during the covid-19 crisis. ESG is demonstrating it can generate returns in both up and down markets.

How would you summarise Kartesia’s approach to ESG?

For us, we have to be innovative because we invest in SMEs that don’t always have the same capability to report on ESG issues as larger companies and our position as a lender may not always allow us to hold discussions directly with management.

ESG is part of every phase of the investment process, from our screening process during origination through to applying ESG to the terms in each transaction. During the holding phase we will annually assess ESG via a questionnaire and follow up on any issues that may arise. At exit we will analyse the ESG lessons we have learned while holding the company to help inform future investment decisions.