Creating diversification has always been at the heart of a strong credit business, with spreading risk across sectors a fundamental of downside protection. But in an age where institutional investors are doubling down on the list of industries they want to avoid for ESG reasons, responsible investment is adding a new layer of complexity to portfolio construction.

Some sectors are clearly more challenging to lend to from an ESG perspective than others, with borrowers engaged in carbon-intensive industries or producing harmful chemicals finding it harder to access private credit than low emissions companies engaged in software, healthcare or education.

But navigating the nuances of good and bad sectors from an ESG perspective is not simple. Even classification under the EU’s Sustainable Finance Disclosure Regulation creates a risk of poor decision-making around sector metrics, as it does not stop Article 8 funds targeting polluting industries.

Investors might rule out backing a highly ESG-motivated venture capital fund if it is classified as Article 6 because it cannot meet disclosure requirements, for example. Yet while an Article 8 fund committed to promoting a social objective may look more attractive, it is not necessarily prohibited from investing in fossil fuel-reliant businesses or in environmentally damaging industrial plants, so long as that is allowed by the fund’s investment policy and it makes the necessary disclosures.

Still, LPs are extending their lists of sector exclusions and asking managers to steer clear of certain opportunities, despite the grey areas.

Alexander Garnier, founding partner and portfolio manager at North Wall Capital, says: “A lot of large institutional investors that invest in managers such as ourselves now have a black mark against backing carbon intensive industries. Others less so. There is a good argument, which is being accepted more and more, that there needs to be a transition from carbon intensive energy production and it can be valuable to support companies with that transition.

“If we were looking at a coal mine, that would be very challenging. A lot of managers are nervous about being branded as carbon investors, and that’s certainly a consideration for all of us. But on the other hand, there is space for helping businesses to transition from carbon to renewables and indeed that is absolutely necessary to avoid further energy price inflation.”

The list of no-go areas is evolving. At Bridgepoint Credit, whose parent company Bridgepoint is owner of ­Private Debt Investor publisher PEI Media, deputy managing partner Hamish Grant says the list of areas where it has a complete ban on investing is growing. It now includes businesses dealing in animal maltreatment, coercive lending, espionage, exploited labour, firearms, fossil fuel extraction and palm oil production, among others.

“We review our investment universe almost constantly and are often considering a new wave of changes. There is a mindset of ongoing review of what should be struck off, partly informed by changes in perceived investment risk and the evolving ESG debate and partly by a reaction to our investors’ changing priorities,” he says.

“The classic example is the separately managed account that wants a complete ban on investing in something. On the one hand, we try to avoid having too many differences between each vehicles’ investment; on the other hand, these investors are very sophisticated so when one identifies a new segment we shouldn’t invest in, we should think hard about extending that approach to other funds. So, there is a feedback loop across our funds.”

Grant says the investment universe broadly falls into three categories from an ESG perspective: opportunities in blacklisted areas, such as fossil fuels; opportunities that are positively encouraged, ie, renewables; and those that are more nuanced where a lender can work to influence a better ESG outcome through its investment.

Bridgepoint Credit has just introduced scoring for Scope 1, 2 and 3 carbon emissions across its portfolio, as the first step on a journey to demonstrating emissions reductions. But still, that should not rule out backing companies in sectors with high emissions, says Grant. “We are always seeking to make our approach to responsible investing ever more sophisticated and over time we will focus increasingly on reducing aggregate portfolio emissions.

“In general, that will steer us away from high emissions companies but not always. For instance, you might have a company with heavy emissions today but where there is a clear plan for material improvement. There your lending is arguably going to have a much more positive impact on the world than backing a software business with low emissions from the outset.”

Challenging sectors

Justin Lawrence, partner in private credit at Adams Street, says some sectors are more challenging but can still present opportunities: “There are some industries that may overall to potentially have higher ESG risks but that we would still consider investing in depending on our level of comfort with the sponsor or company’s ability to manage those risks.

“As an example, we invested in a speciality chemical business after being able to validate the business’s safety profile of its products and historical compliance with regulatory authorities, and the sponsor’s plan to maintain adequate safety and insurance policies.”

He says many ESG sector challenges can be mitigated by the private equity sponsor’s management of the investment: “If the sponsor and company are committed to reducing the ESG risks over time, that could help to mitigate some of the concern.

“For example, if a sponsor-owned company has a segment that operates in a challenging ESG sector and the sponsor has a plan to transition the company away from that sector over time, that would be viewed as a positive mitigation strategy. Additionally, if the sponsor can commit to reporting outcome-related metrics that can be measured over time and has put a plan in place to improve on those metrics in the future, that would also help in the ability to gain comfort with a specific sector challenge.”

Another way to mitigate sector risks focuses on backing the right management teams. Jon Patty, partner at the White Oak Impact Fund and managing director at White Oak Global Advisors, says: “We seek to partner with management teams who have been thoughtful about the ESG challenges facing their sector, who are aligned on taking specific actions on ESG issues, and who are open to ongoing dialogue with their financial partner about continuous improvement.”

A broad approach

Then there are the opportunities to help businesses on a journey to better ESG behaviours, which are by their nature sector agnostic. Tikehau Capital launched an impact lending fund last year, with anchor backing from the European Investment Bank, supporting primarily sponsorless SMEs with the move towards sustainable operations.

Nathalie Bleunven, head of corporate lending at Tikehau Capital, says: “We are targeting all kinds of mid-cap European companies with a will to engage in a transitional approach and commit to an ESG impact roadmap. We have added some additional exclusions on top of our existing exclusions, on alcohol, casinos and armaments for example, and we have chosen to focus on the three themes of climate action, social inclusion and innovative growth.

“We are not excluding companies on the basis of sector though – we wanted to take a very broad approach, more focused on educating and supporting management on their journeys to improvement.”

Bleunven gives an example of an upcoming investment in a fashion retail company – not an obvious choice for an impact fund due to environmental concerns. “But this is a company we have been financing for many years, so we know it well and our head of ESG has helped management to structure their ESG approach.

“They are willing to improve, they have already engaged with us around climate and the supply chain, and they are keen to do more on recycling and gender equality. We are sector agnostic because we know fashion retail is not going to disappear, so we want to help those companies engage. All industries need to transition towards better sustainable practices.”

Garnier says portfolio construction is not straightforward in the age of ESG. “There are impact-focused managers that are just focused on positive ESG outcomes, and there are large asset managers that have launched funds with that label. That’s a very difficult business to be in because you are excluding so many transactions from the off.

“You run into issues with finding transactions and because you are ruling out so much you hit challenges around diversification and correlation. We prefer not to distinguish between compliant and non-compliant investments per se, and instead apply ESG criteria to everything without sacrificing core investment criteria such as diversification, risk-adjusted rewards or downside protection.

“We have risk exposure limits that prevent us putting any more than 25 percent of a fund into solar energy, for example, or from putting more than 7.5 percent with one particular counterparty. Avoiding that concentration risk is important.”

While some sectors clearly do better than others at ticking the ESG boxes, creating a responsible lending portfolio calls for a more granular analysis of a fast-evolving landscape.

A question of emphasis

Some sectors call for more ESG scrutiny than others, but all must be carefully unpicked.

At White Oak, numerous ESG factors are evaluated across sectors, with some more relevant than others. Jon Patty, partner at the White Oak Impact Fund, says: “When performing due diligence on a company in the organic food sector that is differentiated by its regenerative agriculture practices, we need to evaluate how the team approaches soil health, biodiversity, product characteristics and carbon emissions, but we would have a lighter emphasis on their cybersecurity practices.”

But, he adds: “The reverse is true for a company offering a software-as-a-service solution in the education space, or with remote health services, where cybersecurity and the protection of privacy is paramount while certain specific environmental issues are not as relevant. Nevertheless, even sustainable food and agriculture companies need a thoughtful cybersecurity policy and software companies need to carefully evaluate their environmental footprint.”