The ability to generate impact in solving social and environmental problems has become increasingly important for private debt managers in recent years. With more and more LPs looking beyond a narrow focus on financial returns, and European regulation creating a framework for labelling funds, ignoring impact is no longer an option.
Coralie De Maesschalck, head of CSR and ESG at Kartesia, says that linking financing costs to impact performance through a ratchet mechanism can be an effective way of incentivising good performance. The key to success, she says, is carrying out thorough due diligence to select relevant and measurable KPIs for borrowers and ensuring that ratchet mechanisms are linked to a broader sustainability plan.
Why should impact matter for private credit investors?
Coralie De Maesschalck
As an industry, we have a role to play in addressing the social and environmental challenges that the world is facing. The 17 Sustainable Development Goals (SDGs) adopted by the UN in 2015 are an urgent call to action to end poverty, to improve health and education, to reduce inequalities and to tackle climate change. As a lender, we can be a part of that global partnership to achieve the SDGs.
There is a growing trend for investors to demand impact alongside financial returns. We have seen that quite strongly, especially since covid – I think the pandemic made everyone realise that we need to change the way we are living. Regulation is also encouraging LPs to take impact into account.
The SFDR helps investors to understand which funds are actually offering real impact, making LPs more comfortable when investing into funds that have the appropriate labels. Additionally, many investors now have specific mandates to invest into Article 8 or Article 9 funds, creating additional demand for impact orientated products. These trends present an opportunity for us to offer impact for LPs, along with competitive rates of return.
There’s a perception that private debt has lagged behind private equity on ESG and impact. What can be done to address this?
Private debt has been behind but has now caught up. Until recently, we had very few ESG tools dedicated specifically to private debt. For instance, the UN PRI only produced its first guide for integrating ESG into investment decisions in private debt in 2019 – several years after it had developed tools for private equity.
Additionally, there were limited tools available for private debt players from data suppliers. As such, we had to work on the basis of guidelines that were really intended for the private equity market.
Things are changing. The market is growing, and private debt firms have demonstrated a will to also be active players in the development of ESG approaches. For example, we have developed a partnership with the asset management firm Candriam, so that we can combine Kartesia’s expertise in credit solutions with Candriam’s impact know-how.
We seek to invest in companies that can have an impact on at least one of 11 SDGs on which we focus. With the support of Candriam, our impact partner, we perform full ESG due diligence prior to our investment. Working with Candriam’s ESG analysts, we select relevant KPIs so that we can measure impact across the lifetime of our investment in the company.
What are the most effective ways for private debt lenders to create impact?
It will vary, depending on each firm’s values, expertise and resources. We believe that we can drive change by tying our loans to well-designed ESG ratchet mechanisms. With this approach, we can offer an incentive for companies – they get lower-cost financing if they can meet their impact targets.
One challenge is to select the relevant margin discount. We often see discounts of 5 basis points to 15bps being offered as incentives to borrowers. But at Kartesia, we believe that discounts of as much as 50bps are more appropriate to act as a strong incentive.
We determine two KPIs for each company that borrows from us to report on – typically, these would cover a combination of social and environmental factors. An effective ESG ratchet mechanism needs to be accompanied by a well-designed strategy, so that we can really create results that add value. In today’s world, an ESG ratchet mechanism is necessary, but not sufficient.
One of the pillars of our strategy is to undertake deep ESG due diligence prior to our investment. This is critical to ensure that we select relevant and measurable KPIs for the company. Moreover, we also ensure that the two KPIs used in the ratchet mechanism are accompanied by a full sustainability development plan for the company to improve its performance across all aspects of ESG.
What are the best ways to include margin ratchets into practice? Is it more effective to offer incentives, rather than penalties?
The advantages and disadvantages of different types of margin ratchet mechanisms depend on the strategy in which they are used. To achieve impact, we see more advantages from positive margin ratchets that seek to encourage the portfolio companies, which is what we aim to do with our strategy.
Over the last couple of years, we have noticed that pressure on ESG is not only coming from our investors. At Kartesia, we invest in small European companies that are increasingly eager to improve and have started to request our help on ESG. This is mainly because the management teams of European SMEs are realising that SMEs that fail to address ESG matters might not survive in the medium term.
Therefore, in this context, a positive ratchet mechanism is more aligned with the idea of supporting management teams that really have a will to achieve their ESG improvement objectives.
How do you ensure that there are no suggestions of ‘greenwashing’ or ‘impact-washing’ associated with the companies that you invest in?
We have been thinking about impact for a long time at Kartesia, but we didn’t launch our strategy until we were sure that we could avoid greenwashing. We waited until we found a good partner, Candriam. The expertise of Candriam and the reputation of the firm enabled us to feel comfortable in terms of impact, particularly as they have more than 20 years of experience conducting ESG due diligence processes.
We also held on until we had the right internal resources. When I joined Kartesia in 2015, we only had 10 employees – I was head of portfolio alongside my ESG role until 2021, when we grew enough for me to only focus on ESG and CSR. Since then, we have also hired an ESG analyst to help us make sure that we are doing enough work to avoid greenwashing.
And finally, we waited for proper European regulation to be sure that what we call an ‘impact fund’ is officially, according to the law, an impact fund. And this happened with the SFDR last year. Article 9 defines what is called “dark green funds”, which include impact or taxonomy-aligned funds. So, we align with all the requirements to ensure that what we are doing is really recognised as impact.
What have been the broader consequences of the SFDR and other regulatory developments on the impact market?
At Kartesia, we feel more comfortable operating an impact fund with the appropriate regulatory framework in place (SFDR). Asset managers like us must demonstrate that their ESG ambition and engagement complies with the very detailed SFDR requirements. All these obligations might be seen as painful, but actually helped to set up an efficient and transparent impact strategy.
The new European regulations aim to bring more transparency, thanks to all the disclosure requirements. That transparency, plus the fact that the sustainability profile of funds labelled as Article 9 is easier for an investor to understand, reducing the risk of greenwashing, brings more appetite for sustainable debt funds. It’s actually the purpose of the regulation – to make the sustainability profile of the funds easier to understand, more comparable, and reduce greenwashing. Therefore, the SFDR actually creates more demand for impact.
How will impact strategies evolve in the private debt sector over the next few years?
I strongly believe that demand for impact is going to grow substantially. I also believe that impact strategies in the private credit industry will be impacted by the evolution of the SFDR, but also by other regulations and frameworks like the taxonomy or the TCFD. Those regulations already exist, but they will continue to evolve in order to ensure that sustainable investment funds are comparable for all investors.
I also expect to see sustainability-linked loans with increasingly complex ESG ratchet mechanisms that will add greater value. For instance, the number of different criteria and the complexity of those criteria will increase. Borrowers will have to show progress against both static and dynamic KPIs. We could also see carried interest be increasingly linked to philanthropy projects, on top of the margin discount. Overall, I expect ESG ratchet mechanisms to develop so that they become more complete and more complex. Many GPs are already thinking about how to accelerate progress on this topic.
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