1. Private debt is starting to set the ESG agenda

Conventional wisdom had private debt managers lagging behind private equity in terms of commitment to responsible investing but that is changing.

“It used to just be private equity sponsors that were driving the agenda and portfolio companies had the option to say they didn’t want to implement certain initiatives and private debt investors were more dependent on the sponsor to effectuate change,” says Adam Heltzer, global head of ESG at Ares. “Today, that is no longer the case.”

Describing ESG as a hot topic almost underestimates what has happened, Heltzer says. “We’ve seen an incredible explosion in interest. There was a long period of time when investment managers viewed ESG largely as a policy. Now, we are seeing a systematic and scaled approach that brings out an asset manager’s full potential.”

2. Sustainability-linked lending is soaring in popularity

Core to this shift is the remarkable growth in sustainable finance with credit funds lining up to offer sustainability-linked loans. Bridgepoint Credit says it now seeks to include ESG-linked financing on all new primary deals. “The key thing we are trying to achieve with these ESG ratchets is a meaningful improvement on ESG KPIs by incentivising companies to do something that they otherwise would not necessarily have done,” says deputy managing partner Hamish Grant.

AUM of the 220 signatories to the Net Zero Asset Managers Initiative

Amount of funds assets
in Article 8 and Article 9 funds, less than a month after the new EU SFDR rules launched in March 2021

Volume of sustainability-linked loans in the first half of 2021, according to Bank of America

Initial commitments for Baring Private Equity Asia’s first sustainability-linked credit facility

The first close for Amundi’s fourth senior debt strategy, which launched in September with a €1 billion target

Bridgepoint Credit, whose owner Bridgepoint is the owner of Private Debt Investor publisher PEI Media, recently closed an ESG-linked subscription line for each of its flagship credit funds. KPIs reward Bridgepoint Credit’s investors for improved diversity and inclusion and for increasing the number of ESG-linked loans in portfolios.

Anthony Fobel, CEO at Arcmont Asset Management, is taking a similar approach with its strategy: “We are increasingly linking loans to positive ESG outcomes for our portfolio companies. In particular, identifying company-specific ESG improvements that, if met and independently verified, result in a margin ratchet, thereby reducing the interest cost to the company.”

Although not the ultimate owners and controllers of businesses, this enables private debt funds to put in place meaningful incentives to encourage portfolio companies to improve their ESG ratings, he says.

3. LP interest in ESG has ‘grown exponentially’

ESG has long played a role in direct lending, says Permira Credit CEO James Greenwood, but there has been a change in emphasis in recent years that has seen interest widened from pre-deal analysis and screening to include post-investment engagement and monitoring, as well as investor reporting: “ESG has become a more holistic exercise, incorporating every aspect of the investment life cycle, as well as how we operate ourselves as a firm,” he says.

Permira’s head of ESG Adinah Shackleton agrees: “Investors have moved from limited questioning on ESG to a deep-dive approach. LPs are also no longer restricting their assessment of our ESG credentials to our due diligence processes; they want to understand our approach to stewardship and reporting as well. They want to know how we collect and share data and what KPIs we use.”

This has seen fund managers develop new tools. UK-based mid-market lender CORDET has used its own scoring tool to allow for a structured assessment of ESG risks and opportunities. The firm says: “A standardised scorecard method for identifying and quantifying particular ESG risks not only supports our due diligence process, but it also allows us to identify investment opportunities with positive ESG characteristics that we believe improve our portfolio’s risk-reward dynamic.”

4. SFDR is creating a new ‘level of granularity’

One of the biggest regulatory changes in 2021 was the EU’s Sustainable Finance Disclosure Regulation, which came into force in March 2021 and is about to be bolstered by the EU taxonomy rules due to be introduced on 1 January, 2022.

“Firms are really grappling with how to cope with the level of granularity now required”

Paul Ellison
Clifford Chance

Paul Ellison, a partner with law firm Clifford Chance, says the taxonomy is a potential game changer: “Initially, SFDR was done on a principles-based basis, so firms could disclose in a way that was appropriate for their activities. Now we are moving towards regulatory templates for those disclosures, which are more prescriptive, particularly for Article 8 and Article 9 funds.

“Firms are really grappling with how to cope with the level of granularity now required. If you are a debt fund then you won’t always have the same information rights in relation to your investments that an equity investor might have. So, debt fund managers are looking closely at the information rights they have, and what they want to put into new debt agreements when they are doing primary origination to help them to comply with these new reporting obligations.”

5. Impact investing has ‘huge potential’

The new EU regulations do have one big benefit: they are encouraging the debt industry to improve ESG reporting – and that is proving a boon to impact investing, says Coralie De Maesschalck, head of CSR & ESG at Kartesia. “The EU’s SFDR regulations are pushing the industry along a little and helping to foster improved reporting. It’s also prompting the development of products from data providers for private debt specifically, including around ESG.

“Overall, this is helping to spur more impact investment in the asset class and the increased use of ESG ratchets that we’ve seen over the past year or so are really important in effecting change.”

Maria Teresa Zappia, chief impact officer and deputy chief executive officer at BlueOrchard Finance, part of Schroders Capital, believes debt financing is a crucial ingredient in the impact sector. “There is huge potential for debt to deliver impact in whatever specific area of focus is targeted, whether that be a particular geography or a community that is underserved,” she says, citing the example of a Schroders Capital real estate strategy that is focused on tackling deprived areas within the UK.

“There is also enormous potential for debt providers to engage with the financing of low carbon assets. Debt is an extremely powerful tool in the impact industry’s armoury across developed and emerging markets.”