Stephen O’Neill: Debt funds are in strong position to influence ESG behaviour

The head of private markets at Nest says off-market lenders have a lot of power to ensure their borrowers act responsibly.

Stephen O’Neill

As the UK’s largest multi-employer defined contribution pension scheme, the National Employment Savings Trust (Nest) takes its responsibility to its members seriously. What’s the use, it asks, in securing stable retirement income if the world in which you can spend it has been ravaged by climate change and societal disintegration?

But the £12 billion ($15.9 billion; €13.4 billion) scheme also believes that a sustainable investment approach will improve its returns. In July, Nest launched its new investment policy to make the pension net-zero emissions by 2050 and announced it would invest £5.5 billion in “climate-aware” strategies. For more than a decade, Stephen O’Neill, head of private markets and investment proposition, has helped shape Nest’s portfolio approach and philosophy. He is now placing environmental, social and governance issues at the heart of the pension’s long-term portfolio.

How do you consider ESG within private debt?

Nest focuses on private credit deals where our fund managers are among a small group of lenders to a firm, and are therefore directly involved in the negotiation with it on the terms of the loan. This means our fund managers, on our behalf, can use their influence not just to negotiate the financial terms of the loans – the coupon rate – but also the behaviours they expect from the firm.

It is sometimes argued that debt investors can’t exert any influence because they aren’t voting shareholders. We disagree. An off-market lender has a lot of power. Often private lending involves follow-on loans and provisions for the lender to temporarily relax the terms of the loan. These can be withheld if the borrower isn’t doing what is expected of it, whether in regard to financial prudence or ESG behaviours.

Nest therefore carefully picks fund managers that share our perspective on this and which have just as much analysis and understanding of ESG risk factors as their counterparts in the equity space.

How can private debt help an investor seeking to meet specific ESG targets?

We look at our ESG exposure holistically and try to apply our ESG standards uniformly across all asset classes, although we are conscious that there are particular risks within asset classes. Private credit ranges from relatively low risk exposure, in the form of short-terms loans to corporates, to higher risk long-term loans, such as those for infrastructure projects. We make sure our fund managers appropriately discount the pertinent ESG risks when pricing the loans they make.

How can ESG improvements be measured in private investments?

On the one hand, private investments in real assets often have a major and tangible ESG impact – for example, financing a major renewable energy project, be it with equity or debt – that makes a very visible change.

Asset owners can therefore use this part of their asset allocation as a counterbalance to other ‘E’ and ‘S’ risks in their portfolio.

On the other hand, the private corporate space tends to be occupied by smaller companies that don’t necessarily have the resources or incentivisation to be as transparent about environmental reporting, for example. By the same token, being a bilateral counterparty to those firms in a debt financing gives the investor considerable leverage to encourage them to improve and to aspire to the standards of their public market counterparts.