Developing environmental, social and governance practices in relation to private debt is more challenging than would be the case for other investment strategies. Or at least that has been the mantra of some fund managers in due diligence sessions for LPs considering investing in private debt funds.
Recent trends in ESG are challenging this mindset. However, they are also creating avenues for private debt fund managers to help normalise ESG principles within the asset class.
The ESG Disclosure Regulation is part of a new European Union ESG regulatory framework that will affect EU fund managers and non-EU fund managers marketing within the EU. The regulation, which will come into effect in stages from 10 March 2021, provides a tiered set of disclosure requirements at the firm and product levels. These requirements cover how firms integrate sustainability risks in their investment decision-making process. Funds that ‘promote’ the incorporation of ESG factors into the investment decision-making process face additional disclosure requirements about how they achieve this. This suggests fund managers will need to take care not to overstate the case for the ESG principles they have adopted.
Investors in private debt funds will be focused on these disclosures for reasons ranging from their own ESG policies to specific regulatory requirements.
A matter of principles
In 2019 the Principles for Responsible Investment, which incorporates fixed income into its reporting modules, published its Spotlight on Responsible Investment in Private Debt. The paper acknowledged the challenges to implementing responsible investment policies, including difficulties in obtaining information, a lesser degree of influence in certain transactions, and variations depending on types of debt and transactions. However, it also suggested a clear framework and toolkit for private debt fund managers to practically address ESG principles in their investment processes, such as approaches to operationalising, screening, engaging with management, monitoring and reporting.
Private debt fund managers that have established the infrastructure to comply with the PRI reporting framework may be better positioned to manage the requirements under the EU regulation.
The PRI paper anticipated increased demand for ESG provisions in deals’ legal documentation. Obtaining ‘standard’ covenants with teeth in loan agreements is already challenging enough in segments of the leveraged loan market where covenant-lite has prevailed.
In fund financing, however, a form of ESG-friendly facility provided to funds themselves is emerging. Here, the fund borrower does better on the financing margin if it meets certain ESG metrics in relation to portfolio investments. This fund financing technology could be deployed downstream into leveraged finance deals to help provide sponsors and borrowers with an economic motivation for improving ESG credentials.
Private debt fund managers have more work to do, but the rise of frameworks and understanding around what ESG means in practice should help with compliance.