One of the biggest trends over the last decade has been the growth of investor interest in all things ESG. In a few years, private credit has moved on from believing that lenders were powerless to influence the environmental and social impact made by their portfolio companies to now driving forward a new era of impact lending funds and sustainability-linked loans.
A swathe of European direct lenders have launched impact credit strategies in the last three years. Tikehau was among the first in 2021. Vincent Lemaitre, head of ESG for private debt at Tikehau, says the France-based fund manager is increasingly focused on thematic impact funds, starting out with a transition fund in 2021, which was a generic fund investing in various sectors and industries, helping companies transition to more sustainable practices.
“More recently, we have launched one new vintage that is thematic, focused on decarbonisation, and we are thinking of launching another one,” he says. “We think that approach will become more widespread moving forward because of the ability to develop sound methodologies based on recognised standards around that.”
He predicts a harmonisation of approach among investors looking at impact credit moving forward. “Over the last two years, more and more LPs are willing to enter into these impact strategies,” he says. “The most educated ones understand there is a subjectivity around impact and so they are trying to come up with their own standards to guide their own approaches.”
Moving forward, Lemaitre believes the market will come up with a more standardised framework. “We can’t keep going with so many definitions of impact and each asset manager and GP having their own approach. It only brings confusion,” he says. “The growth of this market will be driven by strong definition and harmonisation around the key concepts.”
LPs still have reservations about the perceived lower rate of returns on impact funds, says Laurent Bouvier, founding partner at European specialist Kartesia, which has also embraced impact strategies. “We launched our Article 9 compliant fund a year ago and clearly there is a disconnect right now between what you can find in terms of dealflow for those funds and the support you can get from LPs,” he says.
“ESG strategies today are not strong enough to trigger the interest of an LP if the returns are not at least on par with what they can get in more liquid fixed income strategies. On the dealflow side, though, we have seen a massive increase in opportunities because a lot of money has been raised in private equity for dedicated impact strategies.”
Kartesia has already completed three deals from its impact finance fund. Bouvier says the returns are “slightly below” the typical unitranche in the market, but that the risk profile is much lower as leverage is at around 2.5 times. “That means the risk adjusted returns are fully similar to what we do on the credit opportunities side or on the senior funds side,” he says.
“We are super excited by that opportunity because if the dealflow is already there then over time we will be able to convince LPs that there is a clear path to put money to work in a market where we can make a difference from an environmental and social perspective while still achieving good risk-adjusted returns.”
Another burgeoning area of ESG activity for credit managers has been ESG ratchets, where lenders are now much more routinely offering borrowers the opportunity to reduce the margin payable on their loans if they meet certain ESG objectives.
Such sustainability-linked loans are becoming increasingly widespread in the direct lending market, with the biggest challenges for managers being around the ability to identify relevant and measurable KPIs for borrowers and ensuring the ratchet mechanisms are linked to broader sustainability plans.
Lemaitre believes the further development and penetration of ESG ratchets into private credit is now a matter of building knowhow and expertise internally within managers to support that roll-out globally.
“Standardisation around sustainability-linked loans is improving, but structuring those loans requires expertise to identify and analyse the transitional aspects of the company you are working on. No two companies will face exactly the same externalities,” he says.
The market is moving fast to streamline processes and best practice, with the European Leveraged Finance Association poised to publish updated guidelines on ESG-linked private debt soon and other frameworks being developed.
“It is now without question that diverse groups produce better outcomes”
Blue Dot Capital
Regulators on both sides of the Atlantic are also sharpening the tools at their disposal to combat greenwashing, and they will play a key role in clarifying approaches over the next 10 years. Bouvier says there is a big responsibility on the regulators to now set the rules and publish clear guidelines so that people can really choose how they want to be ESG compliant “and whether they want to be in the driver’s seat or the passenger seat”.
The coming decade will also undoubtedly see a growing focus across the asset class on diversity, equity and inclusion, both within private credit firms and across their portfolios.
For Samuel Hillier, managing director at ESG consultancy Blue Dot Capital, there is clear evidence that diversity boosts the bottom line. “It is now without question that diverse groups produce better outcomes, whether that is investment teams or management teams, so the importance of that initiative is now in wide open view,” he says. “What is going to spread in the coming years is the bifurcation between managers just paying lip service to this with policies and procedures and those truly going out to find and develop the appropriate talent.”
Many ESG ratchets now include a diversity KPI requiring borrowers to address inclusion in their businesses, but more will need to be done.
“The difficulty for the credit space is how many levers managers are really able to pull in portfolio companies,” Hillier says. A growing number of heads of DE&I are appearing at credit firms, taking ownership of DE&I goals.
Financing the energy transition
The shift from fossil fuels to renewables will be one of the key investment themes of the coming decade.
Bloomberg estimates the global transition to clean energy will require investment of as much as $194 trillion by 2050. Global investment in renewable energy increased by 13 percent to $532 billion in 2022, with private capital dominating the funding mix.
Infrastructure debt funds focused on investment opportunities around the safety of the energy supply and energy transition are springing up at pace. In March, Allianz Global Infrastructure reached a €220 million first close on an energy transition debt fund classified as Article 8 under the EU’s Sustainable Finance Disclosure Regulation, or SFDR.
Alexander Slinger, managing director of portfolio management at Arrow Global, says there is a growing opportunity for private debt around the ESG refurbishment of assets. “At the moment, LPs have a huge focus on ESG and the environmental credentials of the assets we are buying,” he says. “There are a lot of assets out there that are not at the level they could be so, for example, we see a big opportunity that utilises a lot of our execution expertise to refurbish brownfield projects. That is an area that is very exciting for us, whether that is through conversions of offices to more premium ESG credentials or small granular social housing projects.”