Having accepted ESG integration as “extremely important” and “foundational” to private debt investment, managers now find themselves in an experimental phase. They are working out “universal principles to centralise tracking and drive outcomes”.
“We don’t have a regulatory or legislative framework we can point to,” said one large fund manager at affiliate title Private Debt Investor’s 2021 Virtual Forum. The industry is “still very much in the laboratory” experimenting with things like tracking data or “using margin ratchets to reward good behaviour”.
The ESG-focused session was conducted under Chatham House rule, meaning speakers – a mixed group of LPs and GPs – could not be identified. On the agenda was the emergence of sustainability-linked loans, whereby certain terms are tied to the issuer’s performance against pre-determined ESG metrics. Typically, they contain a margin ratchet linked to the ESG KPIs.
“We have primarily seen margin ratchets in Europe,” said one investor. “The big questions for these are: what’s material enough to encourage good behaviour… is it five or 10 [basis points] or does it need to be more? And what KPIs do you use to guarantee that initiatives are actually being implemented.”
These instruments naturally lend themselves to the most accurately measurable indicators, which – says the same investor – skews them towards environment-related targets. This is “probably what we expect to continue”, they added. Diversity and inclusion is another area that is well-suited for such structures, added another investor.
Private debt, private doubts
The jury is still out on margin ratchets, however, in part because there is no standard practice. “It is a little bit the Wild West in terms of what people are doing,” said one panellist. “I do think these ratchet transactions make for very good headlines, but I am not convinced they encourage the right behaviour.”
“Those numbers – 5 basis points of motivation – is that enough to encourage the right behaviour? I don’t know,” the doubtful investor said. “It would be nice to have consistency across strategies and approaches. I think we will get there; it is just a question of how.”
Aside from the concerns about the finer details, panellists were optimistic that private debt investors are well positioned to drive positive change when it comes to ESG considerations. While they may not exert the same influence over portfolio companies that a control-investing private equity player might, they do have levers to pull.
“We are providers of capital” said one panellist. “There are ways we can motivate behaviour. We have limitations in terms of access to data, but as we travel along this journey, we can identify things that are deterministic. I am sure we will be using motivational tools as well as penalties.”
The fact that credit investors are used to the presence of covenants in loan documents means “the conditioning is there” for them to request information from issuers. “Asking for it is natural,” said one investor. “We are now seeing obligations to report on ESG in private debt documentation… everyone’s rolling in the right direction.”