This year has been dominated by the covid-19 crisis, which has impacted our daily lives in ways we could not have imagined previously. Although the crisis has undoubtedly been devastating, it may have accelerated the drive for the implementation of environmental, social and governance measures in many areas of the economy. This in turn is opening opportunities for private market participants to be a force for good.
This drive has seen some large investors implement restrictions and ‘blacklists’. Among these investors is the University of Cambridge, which aims to “divest from all direct and indirect investments in fossil fuels” by 2030. However, we have seen ESG implementation go further than simply divesting or restricting investment.
The private debt market should be in a privileged position to bring about change and continue to demonstrate strong alignment of interest with investors. This is an opportunity to demand more from our private equity partners with regard to ESG implementation as we continue to see an increased focus on ESG investing in the wider market.
It is time to look beyond our own investment philosophies and think about using the more lender-friendly environment not just for preferential terms, but also to drive a more sustainable and responsible agenda in businesses across the world.
Driving change in debt markets
The fundamental concepts of ESG have been with us for most of our industry’s history. For many, such considerations are an inherent part of investment decision making and a vital aspect of risk management. Nowadays, ESG investing is ‘just good business’ and enhances returns by avoiding potentially volatile sectors in which increasing regulation, environmental factors or social issues could have an impact on the underlying business model.
The implementation of ‘blacklists’ or ‘negative exclusion’ – where certain sectors, issuers or themes are ruled out – has been commonplace for years. For some, this bare minimum approach has been the extent of their screening process. Now though, we all have the opportunity to do more. A more lender-friendly environment allows the industry to go further and champion ESG leaders, implement ‘positive screening’ and invest in companies that demonstrate positive ESG performance relative to their peers.
Additionally, just as LPs that partner with private debt managers expect strong alignment, the private debt industry should be demanding strong alignment on ESG implementation and adherence from its private equity sponsors. A stronger alignment is likely to yield more positive results in the future.
Since the start of the pandemic, we have seen transactions with more lender-friendly legal and pricing terms than was the case in 2019. This has created an opportunity for ESG-conscious investors to seek to implement formal undertakings regarding ESG targets and information rights. Our first-hand experience has shown that in recent transactions we have found it easier to obtain ESG information from our private equity partners during our due diligence process.
There is an opportunity in the market for greater mutual understanding and co-operation from private equity sponsors – which, in turn, are seeing a push from their own LPs – to work with us and other private lenders on achieving our ESG goals.
ESG-linked subscription lines take off
A concrete example of an ESG development in our market in 2020 occurred within fund financing. In June, we saw the largest ever ESG-linked subscription credit facility, which was backed by a strong syndicate of leading institutions. The margin on the €2.3 billion facility is designed to be adjusted in line with the fund’s ESG performance. The portfolio companies are to be measured in three areas: gender equality on the board of directors; renewable energy transition; and a fundamental sustainability governance platform. These touch upon the ‘S’ and ‘G’ components that are the less commonly talked about aspects of ESG.
The market for ESG-linked subscription lines has taken off this year as borrowers look to incorporate ESG-linked KPIs that can result in potential margin decreases (or increases). MV Credit is looking to introduce ESG KPIs on our own portfolio companies, much like the fund finance industry has implemented when structuring facilities. The majority of transactions completed this year have been for equity funds, but it is only a matter of time before private debt managers move into the space, thereby growing this market considerably.
ESG is touching all areas of fund management as banks also seek to show their commitment to implementing social and environmental practices in their own lending books.
Moving the dial at a corporate level
ESG should be assessed and considered at a corporate level in order to take a holistic view. This is why MV Credit has committed to become carbon neutral to reflect our move towards becoming a more sustainable organisation by improving environmental performance and sustainable growth. We hope more firms in the investment and private debt space will follow.
The pandemic has given us an opportunity to change the way we all do business. We have seen a decrease in business travel for meetings that are now conducted via telephone or video call. Fundraising, a key part of managers’ core activities, has adapted to the current business environment and LPs have become more comfortable in committing their money to a strategy without a physical meeting. Although we do not expect corporate travel to go away, and meeting LPs will still be a key part of a manager’s daily work, we hope that we use this opportunity to make some changes that have a positive impact on the environment and the communities around us.
As managers, investors are at the heart of what we do and the industry as a whole cannot afford to ignore the changing winds of ESG. The conversation around ESG has moved from a peripheral ‘tick the box’ exercise to being at the forefront of the due diligence process and decision-making. The covid-19 crisis will only accelerate the transition towards making more sustainable investment decisions.
We suspect certain areas of the private debt landscape will fall out of fashion, given the increasing focus on ESG. The current market should make an ideal hunting ground for a distressed investor, but will the methods of extracting value be drawn into question? A distressed lender that focusses on ‘loan-to-own’ or ‘short-term profits’ may create conflicts for ESG-conscious LPs.
With a second wave upon us, the market does not look to be settling down any time soon. As a result of today’s market environment, we expect lenders to continue to push for preferential terms, but also to continue to focus on ESG implementation across their whole business.
We hope this is only the beginning in catalysing change for our industry.
Nicole Downer is a managing partner and Harry Elliot an associate at MV Credit, a London-based fund manager