ESG: When principles are not enough

It was September 2016 and the UK’s Environment Agency Pension Fund (EAPF) had a very specific requirement as it sought to identify a private debt fund manager for a £60 million (€68 million; $80 million) allocation. That requirement – for the chosen manager to have in place a credible approach on ESG – meant joining forces with other pensions was ultimately not possible.

“We were engaged by North Yorkshire Pension Fund to do a private debt search at around the same time,” recalls Sam Gervaise-Jones, senior director and head of client consulting UK and Ireland at consultants bfinance. “We discussed the possibility of a collaborative approach and introduced North Yorkshire to EAPF with a view to pooling research and engagement with fund managers. The idea was well received but EAPF’s focus on sustainability reduced the overlap in terms of their requirements. We thought we could bring the two investors in on one piece of research, but it became just about EAPF.”

The brief to focus on ESG may have sounded simple but, as a relatively new asset class that has not had sustainability issues at the forefront of its development, identifying private debt managers that fitted the bill would not prove to be straightforward. Nor did Mark Mansley, chief investment officer of EAPF, ever think it would. Reflecting on the mandate in a bfinance white paper, he said:

“We were very realistic in our expectations here…recognising that the typical sector mix in private debt limits how material ESG issues are in many cases (except for governance) and that the industry is generally at a fairly early stage on ESG integration.”

Outside the box

One thing that was made clear to bfinance from the outset was this would be no simple box-ticking exercise. “It was not just about who was signed up to [the United Nations-supported] PRI [Principles for Responsible Investment] but is ESG embedded into the investment and underwriting process? What is the manager’s commitment to ESG and how is that different to everyone else?” says Dharmy Rai, an associate in the private markets team at bfinance.

Initially, bfinance drew up a longlist of 19 managers (only eight of which were signatories to the PRI principles). This was then whittled down to 10 and then eventually a shortlist of five. Due diligence at this stage delved into the level of governance; whether ESG was looked at on the individual asset level as well as the fund level; and how the existing loan book was managed.

The investigation also delved into team members – testing not just those who had a self-proclaimed focus on ESG issues but other members of the team as well to see whether these issues were widely embraced and could genuinely be described as a corporate culture. The results were often illuminating according to Niels Bodenheim, director of private markets at bfinance, who said in the white paper:

“You need to hear from a range of people. If the ESG person comes and presents then of course you will hear that ESG is fundamental. You need to question the people that are doing the transactions day to day. You also need to hear from the people who do the monitoring. The approach to work-out – how the manager treats distressed situations – is very important with private debt and very much has an ESG dimension: is it consistent with ESG principles, i.e., not fee-generative but really involving working with the companies to make sure sustainability and governance aspects are high priority?”

It wasn’t only ESG that the EAPF was focused on. In terms of the GP’s team, it wanted to know whether there was any workout experience and how team members acted in a workout scenario. If they had shown too aggressive an approach, that would make them appear less suitable than those who took a more collaborative and consensual approach.

The overall track record was unsurprisingly a factor as well as the level of fees charged. “The EAPF invests on behalf of its contributors so while there is an ESG/sustainability focus, the manager also has to offer cost efficiency and make good returns,” says Gervaise-Jones.

US in slow lane

But ESG was certainly an important factor, at least as far as European managers were concerned. In the US, bfinance found a somewhat less enlightened approach. “European managers were ahead of the game,” says Bodenheim. “It was already a part of their process. The larger managers would typically have separate teams that everything related to ESG would get funnelled through. In the US some managers have put ESG policies in place but they are not well embedded yet.”

bfinance says it has found UK local authority pension funds and Canadian investors to be among the most switched on when it comes to ESG issues.

Interestingly, EAPF was broad-minded when it came to the sectors that they were prepared to allow managers to invest in. A number of local government pension schemes in the UK have specifically excluded investments in areas such as tobacco and weapons while, in the US, marijuana is a common exclusion.

But while EAPF did not rule out any particular sectors, it was keen on managers making societally beneficial investments. In the end it selected a number of GPs, one of which was a growth capital investor which was perceived to be “focused on job creation, operational efficiency and reduced carbon footprint”.

The only allocation from EAPF which was publicly disclosed was a £60 million commitment to Permira’s Credit Solutions III fund. EAPF said in a statement it was “impressed by their [Permira’s] focus on senior loans with modest leverage, their track record and their organisational commitment to responsible investment”.

BFINANCE’S MANDATE AT A GLANCE 

*Net IRR target of 6-8 percent+, regular income distributions of 6 percent.

*Strategy focus of corporate debt, buy and hold. Open to most corporate debt types across senior, unitranche, with limited exposure to subordinated and mezzanine investments.

*Predominantly focused on Western Europe including UK but could consider global.

*Duration target of 8-10 years.

*Investor wishes to represent no more than 25 percent of fund commitments.

*The strategy should consider ESG sustainability.

Source: bfinance white paper, “ESG Under Scrutiny: Lessons from Manager Selection”

EARLY OR LATE: THERE’S NO RIGHT ANSWER 

Through having examined the relative merits of 19 managers for the EAPF mandate, bfinance says it was able to identify two broad approaches to ESG: early incorporation and late-stage assessment.

Early incorporation involves ESG factors being considered during the first phase of screening for deals whereas later-stage assessment only takes account of ESG as part of the final approval process.

In its white paper, bfinance says the latter approach does run the risk of becoming wedded to the opportunity before considering the ESG aspect. However, the firm does not take the view that one approach is necessarily better than the other.

“There always a flip side,” says bfinance’s Niels Bodenheim. “When a firm does ratings – rating the level of ESG risk from low to moderate to high – what’s actually done with that information? We have done due diligence on managers who do deals that were given a high-risk ESG rating by their own process.”

Source: bfinance white paper, “ESG Under Scrutiny: Lessons from Manager Selection”