In early April, the European Commission adopted the final regulatory technical standards for the new Sustainable Finance Disclosure Regulation, belatedly specifying the mandatory website, pre-contractual and periodic reporting templates that asset managers will need to comply with from January next year.
These details have been a long time coming – and are still subject to approval by the European Parliament and Council – but finally add some clarity on what regulators will be looking for from managers on ESG reporting. Throw in the escalating demands coming from other regulators, and critically from investors, and private credit funds face an immense and fast-moving ESG data challenge.
Private debt has come a long way on ESG; as recently as two years ago, many managers thought that as lenders their ability to influence portfolios on ESG was limited at best. Today, most are embedding ESG in investment processes, but still regular reporting will present challenges.
“Most private debt funds are now trying to conduct ESG evaluation within every step of the investment value chain, including fund and sector screening, due diligence and portfolio management,” says Antonis Anastasiou, head of AIFM at Alter Domus. “More financial institutions are also signing up to overarching ESG and sustainability guidelines, such as the UN’s Principles for Responsible Investment, which we are also signatories to. But to deliver truly best-in-class ESG reporting, debt funds need access to consistent and easy-to-consume data, which is harder to come by.”
Extracting detailed ESG information from borrowers is hard and credit funds come in all shapes and sizes, making it tricky for the asset class to develop standard approaches to data capture and reporting.
“The key thing is that it is not a one-size-fits-all approach,” says Michael Raymond, partner at law firm Travers Smith. “Best practice will vary from manager to manager. Within credit there are a wide range of strategies, which might include European listed liquid credit, through to structured credit, through to private debt special situations where it could be incredibly difficult to get metrics. The readiness of managers to report on all this depends on strategy, but people have done a lot of work in the last year and now have firmer ideas of what they can get and what it is going to be possible to share in the short, medium and longer term.”
While European regulators clarified some of their expectations, Raymond says managers should continue to deal with the data challenge as an evolving piece, liaising with LPs and keeping in mind the art of the possible.
Five keys to best practice in reporting
The issue of ESG data collection and how it is reported has become a key focus. Fund managers are advised to:
Demonstrate ESG is embedded into due diligence.
Be transparent with LPs and borrowers via ongoing dialogue on the data challenge and approach.
Bring in third-party data that is relevant, informative and useful.
Take a measured and thoughtful approach to the use of estimations and modelling.
Embrace collaboration with peers and industry bodies to enhance harmonisation efforts.
At Kartesia, Coralie De Maesschalck, head of CSR & ESG, says the priority is to be as transparent as possible in ESG reporting. That means quarterly updates to investors, with an ESG section and an SFDR section included in LP reports, as well as an annual public sustainability report published online and annual reporting to the UN PRI.
“The biggest challenge is getting the data,” says De Maesschalck. “We are investing in small companies that don’t always have all the required information. Also, there is still a lack of tools dedicated to private debt, especially SMEs. On top of that we are not owners and might not have direct access to management in certain cases. For all those reasons, getting the data is sometimes an issue.”
Thierry Vallière, global head of private debt at Amundi, says the challenge comes from the wide range of situations and companies that it deals with across Europe: “Some are small or mid-sized companies, sometimes we are only financing assets, and the regulation differs from country to country. It’s really a big challenge to access the relevant data in order to be in a position to measure that over time and to ensure comparability from one company to another and from one country to another.”
Nevertheless, the firm is moving towards more regular ESG reporting. “We are working with our companies to gather information, and we are doing some ESG reporting where we highlight some specific KPIs that are in line with the UN’s sustainable development goals,” says Valliere. “We have chosen four of those that we are working to report against, identifying specific relevant KPIs. We do that reporting once a year because having access to that data today is really tricky.”
It is not just SFDR weighing on the minds of managers. The UK has announced its own sustainability disclosure requirements and, in the US, the Securities and Exchange Commission has said it, too, is considering rules for private funds and other investment advisory businesses regarding ESG factors.
At law firm Proskauer, partner Kirsten Lapham says the near finalisation of the technical standards for SFDR means that managers can get on with engaging with them in a meaningful way. “For private credit, the limited availability of data is the real issue and managers are speaking to us about how to go about obtaining relevant data,” says Lapham. “That can involve building contractual provisions into loan agreements to ensure access to available information, or engaging with service providers to collate information from publicly available sources to do modelling.”
For the most part, the asset class is well prepared, she adds: “Most managers have accepted this is happening and have done as much as they can to engage with it. Managers that we work with are populating those templates that are not required until next year, to get as ready as they can and put processes in place. Even the smaller managers or first-time managers are pretty engaged and have invested quite significant money, resource and time to get in good shape.”
She says more data will become available over time, and more guidance will come from regulators around acceptable approaches. “We are expecting to see a bit of a hotch-potch of best efforts to start with, and disclosures will all look a bit different, but after a few years the market will evolve and become pretty coherent.”
At Blue Orchard, the global impact investment manager that is part of Schroders, deputy CEO and chief impact and blended finance officer Maria Teresa Zappia says data is scarce in emerging markets: “That said, we are engaging very actively with a range of data managers to see how this will improve over time, and how coverage of emerging markets will improve.
“There is a way to go, and regulators are aware of that. The train has left the station and we are all learning and working together on data availability and awareness.”
In addition to regulators, limited partners are exerting even further pressure on managers to deliver ESG data, often taking disparate approaches.
Alter Domus’s Anastasiou points to carbon emissions as an example of the challenge: “GPs still struggle to source, capture and share data around some of the most frequently requested metrics, particularly around Scope 1 and 2 carbon emissions. According to the 2021 Bain survey, fewer than one quarter of GPs could provide LPs with data on Scope 1 and 2 emissions all or most times that it was requested, while less than 30 per cent could provide data on all principal adverse indicators all or most times.”
So far, most LPs have focused their attention in credit on ESG due diligence being done by managers. Proskauer partner Monica Arora says: “Our private credit managers all conduct ESG diligence and most LPs are requiring that, so at a minimum they are saying they want to understand the processes that are gone through when making a loan. They want to make sure managers are doing what they say they are doing.
“What we haven’t seen much of yet is LPs wanting regular reporting, but that will change.”
Apollo’s head of ESG Credit, Michael Kashani, says: “We are having really constructive calls with our LPs on this, because they want to engage in a dialogue and be educated. Their questions centre first and foremost on our foundations for assessing ESG risks and opportunities, and then on transparency around reporting and consistent dialogue.”
On reporting, he adds: “Some of our flagship strategies report on ESG on a quarterly basis, while annual tends to be the construct for many of the regulations. At the very least, LPs are looking for an annual touchpoint with us on this. But data disclosure is only part of the story: we actively encourage our LPs to meet with us once a year to go through this, so they can ask questions about the investments we have made and probe our processes, which continue to evolve.”
Regulators and investors are moving in tandem to drive more data disclosure and demand more visibility on how managers are addressing ESG considerations with borrowers. It’s a challenge managers will have to rise to.
Sourcing the data
Credit managers sourcing ESG metrics on borrowers must rely on three sources: the companies themselves, third-party data providers tapping public sources, and estimates based on peer group analytics and modelling.
Coralie De Maesschalck, head of CSR & ESG at Kartesia, says: “We built up a model based on peer analysis with a third-party supplier to estimate the carbon footprint of each of our portfolio companies and then to aggregate it to each of our funds and compare it to benchmark. Our portfolio companies are too small to report on carbon footprint, so we decided to use modelling to compensate the lack of data.
“We received a lot of invitations for webinars from data providers that would help asset managers to source mandatory data, required to be compliant with SFDR. I attended many of them but the issue was that 90 percent of our portfolio companies are not covered by those new solutions because we invest in quite small companies. Therefore, first we try to get the data from the company itself by using ESG questionnaires that are sent on an annual basis. And for the data that companies cannot provide, we try to use models.”
At Apollo, head of ESG Credit Michael Kashani says: “That’s an area where some LPs would rather not have estimated data, while some others are looking for that in order to get to a better coverage level across their portfolios.
“The difficulty with estimated data is when you are asked to make investment decisions based on that. It can be very useful in understanding where a company sits on a spectrum, but making investment decisions solely based on a high level of estimated data is concerning. We believe the market needs to evolve a bit from where we are now and significantly improve the level of disclosure.”