Why debt fund managers must tread carefully on ESG

Progress has been made but more still needs to be done as GPs strive to make their sustainability efforts meaningful.

Environmental, social and governance is an area where private debt fund managers have been playing catch up. In one sense, it could be argued that they’ve caught up. Not too long ago, equity providers were seen as the main – or even only – drivers of operational change, of which ESG is a part. Lenders were seen as passive participants in deals – useful as finance providers; not that useful for much else.

That perception has changed. These days, the debt side of the equation is viewed as being at least as influential as the equity side when it comes to assessing a company’s ESG credentials and then holding them to certain standards. But, in a sense, private debt funds are still playing catch up: when compared with the banks, that is.

One source interviewed for a cover story to appear in our July/August issue expressed the view that it’s the only remaining area where the banks are a step ahead of the debt funds. “I think it’s more embedded and higher up the agenda within the large clearing banks because they have the dedicated resource to really get their arms around what ESG means,” they said.

The banks have the heft to conduct extensive due diligence and are strong in areas such as reporting and data. Going into ESG anything other than fully committed is a recipe for trouble. Some say private lenders are better off not making ESG considerations part of their investment process at all if it means opening themselves up to a toxic cocktail of reputational, legal and financial risks.

The main contractual tool used by private debts funds for ESG enforcement has been the margin ratchet – by which interest payments can move up or down depending on a borrower’s success or failure at hitting pre-agreed targets. But, while the ratchet has become almost universal, it has also attracted controversy.

One objection is the discomfort felt at lenders benefitting economically from an increased margin that has resulted from ESG underperformance. Another is the accusation that, in many cases, the ratchet doesn’t make a material difference – either on the upside or downside. On the whole, the view is that they do serve a useful purpose in ensuring that borrowers take lender concerns over ESG seriously – but the potential sting of the ‘greenwashing’ label still lurks in the background.

Few would dispute that much progress has been made by debt managers on ESG, but given the harsh spotlight on the topic these days there remains much to be done.

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