Private credit fund managers, and their investors, are increasingly engaging in the importance of environmental, social and governance (ESG) issues in their investments.
There is no doubt that this is in part the product of markedly increased public – and hence investor – concern about climate change, social impact and diversity issues since the onset of the covid-19 pandemic. Equally there is increased acceptance that ESG factors, such as climate risk, strengthen the accuracy of lender’s related credit risk assessments.
There is a wide range of means to integrate ESG in investment processes, and currently not much cohesion in the expectations and approaches taken by both sponsors managers and their investors.
Part of the lack of cohesion stems from the wide variety of tools that a lender can use to assess ESG risks. Lenders have, in principle, a wide range of sources of ESG information, such as: publicly accessible “reputation risk” databases; questionnaires to submit to borrowers (addressing, for instance, the borrower’s greenhouse gas emissions) in various formats, including those used by credit rating agencies and the tailored formats offered by the Sustainability Accounting Standards Board (SASB); and generic information on the ESG risks that apply to particular industries. Lenders inevitably face challenges in collecting such information in a consistent manner, particularly where they are part of a lending syndicate.
On the borrower side, a current issue is the number and variety of ESG questionnaires they receive from lenders. It is helpful to note that, in the public bond market, the Loan Market Association is developing a “roadmap” for incorporation of ESG related disclosure into bond offerings, which includes encouraging issuers to disclose ESG data in a consistent manner, such as their carbon footprint.
Lenders also have a challenge in defining the importance of ESG in their investment process. A mainstream view is that ESG is one factor in determining the creditworthiness of an issuer, with “elevated” ESG risk not necessarily precluding a lender from investing in an issuer if the risk is offset by the credit’s overall fundamental strength. Arguably, ESG issues affect a company’s financial performance in longer time periods than is the focus of many lenders. Furthermore, materiality of an ESG issue, particularly where the data is qualitative, is inevitably a matter of judgement. There are also differences on the impact of ESG factors between different business sectors. Nevertheless, effective governance – a wide term encompassing the role of the board, the treatment of employees, anti-bribery and corruption policies, and effective compliance – will be important to all sectors.
If lenders conduct intensive ESG screening or score-carding and want to pursue specific environmental or social themes (such as climate change risk) in their investments, they will need to consider whether the size of their dealflow allows them to do that, and the resulting impact on their diversification.
Collecting a suite of ESG information upfront may well imply a degree of ongoing engagement with the borrower on ESG themes which lenders cannot necessarily achieve – and lenders, having promoted the quality of their ESG screening to investors, face the reputational risk of a company in their portfolio subsequently being subject to a widely publicised adverse environmental or social event.
If lenders want to apply ESG to their lending in a more concrete way, it is open to them to include specific ESG terms in lending documents that prescribe ESG reporting obligations, standards and targets. While there are currently no standard market terms, “sustainability linked” loans, which measure the performance of the borrower against certain external ESG metrics (such as reduction of carbon emissions), with that performance triggering certain outcomes (such as an adjustment to the margin associated with the loan), are increasingly common.
Despite the engagement shown by investors in ESG issues, it is fair to suppose that there is little cohesion in the approach investors take to both screening their investments in private credit managers in consideration of ESG issues and dealing with the flow of ESG related information that they receive. This, in part, might reflect a degree of confusion over whether consideration of ESG issues amounts to any qualification of their fiduciary duties as investors to maximise returns on a risk adjusted basis.
A common message from private credit lenders is that ESG engagement is both a journey and a learning curve, with much work to be done by lenders in refining their process and the quality of information they receive.
John Young is an international counsel, and Sophie Michalski a trainee associate, at Debevoise