Private lenders must follow banks in avoiding a bad ESG look

Progress is being made in encouraging borrowers to take their ESG responsibilities seriously, but is it being made by private lenders? A recent conversation with a leading private funds lawyer drifted on to the topic of sustainability-linked loans. He’d seen a smart one, he said, in which if ESG-related KPIs were not achieved, the extra interest paid as a ‘punishment’ would go to charitable causes. This sidestepped one criticism of SLLs which is the “bad look” associated with lenders financially benefitting from sub-optimal ESG compliance.

But this was a deal which, on the lending side, comprised three banks. Nor is this a coincidence: thanks in large part to having more resource to throw at it, ESG is one area where banks are perceived to have a significant advantage over private fund lenders (one of few areas it should be added, but clearly an important one).

The most commonly employed tool for lenders to encourage better ESG performance is the margin ratchet, by which payments move up in the case of failure to hit pre-agreed targets and down in the case of successful execution. This is a neat solution but many would say limited in its scope – the basis point difference is in many cases so small that it makes little material difference to the company in question. At worst, it may be seen as tokenism or even as an aid to greenwashing. In defence, lenders would say it’s a lot better than nothing – which is precisely what was being done before the first SLL was completed around six years ago.

Speaking to an executive at a private markets firm this week, they stressed the importance of ESG as part of the credit diligence process. While ratchets may help – particularly when it comes to certain industries – there’s no substitute for having done heavy lifting at the point of investment in order to decide whether, from an ESG point of view, this is a business you want to be partnering with. The comparison was made with covenants – you wouldn’t invest in a bad business just because you could get tighter covenants; in the same way, no amount of margin ratchet innovation will compensate for some fundamentally flawed aspect of a borrower’s ESG approach.

Last week, Partners Group published a white paper regarding the migration of capital from public to private markets, along with private markets’ increasing stewardship of real economy businesses. This transition clearly arises from the great success of private markets, but also poses challenges. How to help guide companies towards ESG best practice is one of them – and the onus is on lenders to demonstrate they can play their part.

Write to the author at andy.t@pei.group