Key takeaways: Lenders have a central role in pushing the ESG agenda

There’s a growing realisation that private debt fund managers have a crucial role to play in ensuring better environmental, social and governance outcomes.

Whether it’s through dialogue or data, sustainability-linked loans or social responsibility, gender diversity or GP engagement, there’s a growing realisation that private debt fund managers have a crucial role to play in ensuring better environmental, social and governance outcomes.

To take stock of recent developments in the responsible investing arena, Private Debt Investor asked leading fund managers to help compile this A-Z of ESG and to comment on the topics that resonate most strongly with their operations. Here are seven key takeaways from the report.

Data matters more than ever

ESG data and KPIs are moving up the agenda in private debt, especially where due diligence and sustainability-linked loans are concerned.

“The market right now is volatile and exacerbated by macroeconomic factors, which makes ESG more important as a tool for business resilience,” says Salma Moolji, European ESG lead at Ares Management.

For Ares, the priority is sustainability-linked loans with a focus on “measurable indicators”, KPIs with an emphasis on more credible and measurable data, and “deepening our commitment across our portfolio to more specific and more urgent themes, including climate change and diversity, equity and inclusion”, Moolji says.

Due diligence is at the heart of ESG

Lenders are now increasing their focus on ESG credentials at the start of the investment process and are devoting more resources to due diligence.

“The due diligence process for direct lending takes multiple weeks and has different stages, with ESG analysis featuring throughout,” says Michael Curtis, head of private credit strategies at Fidelity International. “This includes during our loan documentation negotiations, because there will be commitments that we will be looking for from borrowers that pertain to ESG.”

Curtis says a key factor in the overall perception and rating of a business is the assessment of the company’s general commitment to engagement and change on ESG: “You can send a 160-page questionnaire to a company to fill out and they can respond, but we are not just looking for disclosure, but a genuine assurance from companies to commit to substantive ESG targets.”

Lenders are becoming ever more mindful of social issues

Environmental and governance considerations in ESG have typically taken priority as they were considered easier to understand and track, but there is growing commitment to social responsibility.

Social factors should be embedded into all risk management and investment decision-making frameworks, says Paul Woods, director of sustainability, at Arrow Global.

“Organisations need to be able to understand and quantify social considerations alongside any other investment criteria irrespective of the economic cycle, because if a manager is going to generate a long-term return, then neglecting the ‘S’ is going to create problems down the line,” says Woods

“This is now so embedded in most firms’ investment approaches that it is unlikely to slip away.”

Carbon reporting is a growing priority

Private debt firms are increasingly making commitments to reduce their portfolio-level emissions – which entails measuring and reporting emissions across portfolio companies. But this is easier said than done.

“Very few private middle-market companies have been able to calculate their Scope 1 and 2 emissions and almost none [for] Scope 3 emissions – they generally don’t have the expertise or resources to do so,” says Mickey Weatherston, head of sustainability and ESG integration at Churchill Asset Management, an investment specialist affiliate of Nuveen.

In the meantime, given the difficulty in collecting data, Weatherston says that modelling is the “best way to provide our investors with a reference data point on carbon emissions”. Churchill engages specialist third-party data providers to model emissions for its portfolio companies, based partly on emissions reported by companies with similar characteristics.

Private debt is starting to embrace impact investing

Achieving positive social and environmental impacts is a top priority for a growing range of investors, with the market for impact investing estimated to have reached $1.164 trillion, the Global Impact Investing Network announced in October.
The private debt industry is looking to impact investing, partly in response to pressure from asset owners.

“There is a growing trend for investors to demand impact alongside financial returns,” says Coralie De Maesschalck, head of CSR and ESG at Kartesia. “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.”

De Maesschalck notes that the EU’s Sustainable Finance Disclosure Regulation, or SFDR, which created the Article 9 designation as a label to allow managers to differentiate impact funds, has helped spur investor interest. “The SFDR helps investors to understand which funds are actually offering real impact, which is making LPs more comfortable investing into funds that have the appropriate labels,” she says.

Alignment can achieve better outcomes

Private debt managers can achieve better ESG outcomes if they align their interests with multiple stakeholders – including sponsors, LPs and the management teams of portfolio companies.

While still nascent in private debt, Emilie Huyghues Despointes, ESG officer at MV Credit, says the European credit specialist plans to link carried interest in its future funds to ESG metrics. This would see executives rewarded for the firm hitting its KPIs relating to ESG.

Meanwhile, it is, of course, also critical that private debt lenders align with sponsors in their approach to ESG. “We used to hear a lot that it’s not the place of the lender to engage the borrowers and try to provide support on ESG,” says Huyghues Despointes. But things are changing. She says she is regularly invited by MV Credit’s main private equity sponsors to attend quarterly calls or site visits, and notes that sponsors and lenders are working together to find ways to help streamline ESG reporting for portfolio companies.

LPs are demanding more transparency

Investors and regulators are demanding greater transparency from lenders on the ESG performance of their portfolio businesses. Antoine Peter, manager at Arendt, cautions that transparency “can be a bit of a double-edged sword”.

“On the one hand,” says Peter, “many asset managers want to inject more transparency into their fund offering documents in order to protect themselves against mis-selling claims and make sure that they are meeting the expectations of their investors. Everyone has a different definition of what ‘sustainable’ is, and so greater transparency helps fund managers avoid some of this confusion.

“But, on the other hand, increasing transparency also risks exposing fund managers to greater levels of scrutiny and criticism by allowing investors to gain a better insight into what is actually going on. This is not just about what NGOs and journalists might think. It is also about how investors see things.”