Loans are going green, but is it enough?

ESG and sustainability are now being worked into deal documentation, but it may take a while before the private debt industry is seen to be truly making a difference.

Was it the transition to working from home that led to one of the biggest emerging themes in private debt over the last couple of years? Speaking to affiliate title Private Debt Investor this week, a senior executive at a European fund of funds manager volunteered precisely that theory – forced into remoteness and without office distractions, fund managers found themselves thinking big strategic thoughts. And one of the most important was around sustainability.

It may or may not be a coincidence, but it was in the early months of 2020 – as the first big wave of covid was hitting many countries around the world – that private debt fund managers took the first tangible steps towards incorporating ESG and sustainability targets into their deals. This was done predominantly through using margin ratchets, designed to reward borrowers for the attainment of agreed targets with lower interest payments.

Since then, margin ratchets have gone from being a novelty item to a widely accepted feature of loan structuring. They have also courted some controversy, with accusations that they are not sufficiently material to make much difference to borrower behaviour. Some are already expressing a preference for ESG- and sustainability-linked covenants, with the prospect of possible default hanging over a badly behaving borrower. Some think more stick and less carrot is the way forward.

There is some merit to a more punitive approach, and also substance to the claim that it’s all been a bit ‘softly, softly’ so far. The last thing the asset class needs is for accusations of greenwashing to stick. It should therefore make sure it learns lessons from the broadly syndicated market, where criticism has been more vocal. At its worst, private debt has a tendency to clone some of the most reputationally damaging deal documentation from the BSL market. When it comes to ESG and sustainability, it should adopt more of a free-thinking approach.

But the criticism should not be overdone. Only a year and a half has passed since margin ratchets first appeared on the scene and today’s model for ESG and sustainability implementation is a rudimentary one that will surely be refined and improved as the years go by. At this point, good intentions count for a lot.

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