This article is sponsored by Kartesia
What particular challenges do debt funds face when it comes to environmental social and governance issues, given their limited influence over management? What does this mean for due diligence?
That’s a very important question for a player like us. Kartesia’s mission is to provide liquidity and credit solutions to small and medium-sized companies in Europe. As a lender, we may not always have direct access to management, and the first challenge is that there is no consistent view on ESG best practice for debt funds. The level of agreement on how to implement ESG is much lower than in private equity, in part because private debt is much smaller. When you don’t have proper tools to compensate for limited influence it is a challenge. We nevertheless expect best private debt market practices to evolve quickly.
The relatively low level of ESG reporting by small and mid-market companies is another challenge. They are so small sometimes that they don’t even have policies, so you really need access to management to get details or convince them to collect information.
What does that mean for due diligence? It means due diligence needs to provide debt managers with negotiating power that is effective. The due diligence phase is critical because it is the chance to request management changes related to ESG at an early stage of a deal. It is also when we can get companies to understand our reporting requests. Our ESG questionnaire, for example, runs to four pages. We ask them to fill that out annually. Our thinking is that if they are required to complete it during due diligence, they are much more willing to update it each year.
As lenders rather than owners, private debt funds often have little or no direct influence over the strategic direction of the company, so strategic ESG due diligence is critical. We have to identify ESG issues during the early due diligence stage because it is hard for us to ask for improvements later.
Given the importance of the due diligence process from an ESG perspective, how should approaches differ between primary deals, where debt funds are doing their own due diligence, and secondary deals, where they are reliant on processes run by sponsors or other lenders?
The challenge for secondary investors is around even more limited access to ESG information and even more limited access to the management of portfolio companies.
We have adopted a different approach for different types of deals. For primary deals, we have more access to information and so we have several tools, the main one of which is our ESG due diligence questionnaire. We have direct access to management and we can put pressure on them to ensure that the questionnaire is filled out on an annual basis.
“Covid has changed the way ESG is viewed by investors and managers, highlighting real vulnerabilities and social inequalities”
On secondary deals, when we are buying debt from others, we are relying on the due diligence of the sponsor. It is much more complicated to ask them to complete the questionnaire, or even to get access to someone who could fill it in. So, we use other tools, the first one of which is making sure our expectations are aligned with the sponsor’s.
Access to sponsors is relatively easy, so the deal team spends time exchanging information with them on several topics. It might also happen that I meet their head of ESG and discuss their policy. Other tools include screening, to exclude certain sectors that are too risky, and investment scoring based on conversations with the deal team and external experts to identify ESG risks.
Post-investment, we use modelling to compensate for the lack of data. We work with a third-party provider to estimate the carbon footprint of portfolio companies by analysing their peers, for example.
Finally, on CLO deals that involve hundreds of underlying companies, we analyse the ESG policy of the CLO management to make sure it is aligned to our own.
What lessons have you learned as a business about running the ESG due diligence process?
Kartesia was started in September 2013 and most of the tools we use have been built since 2015, when we created my ESG function. We have learned to focus on aligning our investment with our values, because ESG means different things to different people.
We also learned to operationalise ESG within Kartesia, meaning all staff members need to take responsibility for our values. For us, it is about fully integrating ESG into the organisation, not treating it as a separate department or a marketing tool. We have a centralised department, but everyone is doing the job. We have clear ESG procedures and training for the whole team.
How do you see market practice developing in this area, and what trends do you anticipate will be front of mind around debt fund ESG compliance in 2021?
For sure, the market will be impacted by the EU Sustainable Finance Action Plan – the Carbon Benchmark Regulation, the Disclosure Regulation and the Taxonomy. The Disclosure Regulation is due to come into force in March 2021 and we expect the final text before the end of this year, creating a challenging implementation timeline. We expect that to be a big focus for private debt next year – it will be tough, but we do really need a plan for sustainable finance in the asset class.
The second challenge is covid-19, which has already impacted investment processes and due diligence. Covid has changed the way ESG is viewed by investors and managers, highlighting real vulnerabilities and social inequalities. We expect investors and fund managers to prioritise investing with a conscience – we have added new questions to our questionnaire, for example, including around the ability of employers to offer flexible shifts for those unable to work from home. In the long term, I would like to see borrowers’ access to capital being dependent on their ESG performance. That is a theme I expect to see more of in 2021.
What should ESG due diligence focus on?
It depends on the deal, the country and the previous experience we have had with similar businesses. ESG issues should not be seen as a checklist. Investors should consider which ESG issues are most important for the company they are lending to. It is an ad hoc analysis because issues are different in every industry.
For Kartesia, the focus includes applying ESG screening to exclude sectors we consider too risky. Then we identify ESG red flags during due diligence, because we are not able to change things later. Then, it is important for the deal team to consult me – particularly if it’s a sector we haven’t done ESG due diligence analysis on before – and to integrate ESG scores into the investment memorandum. We now have an ESG scoring and summary in every deal memo. Finally, ESG should focus on data mining and monitoring, so we look from the beginning at what we will be monitoring.