Investors, alongside governments, businesses and individuals around the world have started to talk about what they can do to ‘build back better’. Investors have a significant role to play in making this happen, and 2021 is set to be a big year for environmental, social and governance (ESG) investing, impact strategies and climate change action.

Lobbying pressure and new rules, such as the European Union’s new Sustainable Finance Disclosure Regulation, alongside the build up to the UN Climate Change Conference in November (COP26) are giving fresh impetus for change. While ESG and sustainable investing have been well-established across public markets for some time now, private markets are starting to catch up rapidly and looking for consistency and methodologies to adopt.

“The ability to build long-term working relationships with borrowers and issuers is extremely helpful, especially when it comes to impact investing”

It is hard to apply a one-size-fits all approach to ESG analysis in private credit, given the unique risks and attributes of the wide range of asset classes that make up the investable universe. This range could include assets such as direct property investment, direct lending and private ABS markets, so there will be specific risk factors and thematic issues that are more applicable to some areas of private credit but not others. Alongside this, the time horizon of investment can vary enormously and the impacts of certain ESG-related risks may develop with time, so ongoing monitoring and engagement is crucial.

However, private market investment lends itself to sustainable investing not least because private credit managers routinely talk directly with investee companies – enabling them to signal the importance of sustainability as an issue and ask key questions before lending. The ability to build long-term working relationships with borrowers and issuers is extremely helpful, especially when it comes to impact investing. As private debt typically finances discrete projects or smaller businesses, it can be easier to identify, define and measure the positive social or environmental impact, compared with investments in large public companies. Furthermore, a small company with just one or two bond investors is usually keen to engage, offering access to management to facilitate this. In general, we have been very encouraged by the level of engagement from companies we invest in as they also seek to change their ways of doing business.

Finding a benchmark

Nevertheless, there is still a need for more consistency in sustainability and ESG metrics across private markets. ESG risk management and considerations have become mainstream in public markets and the emergence of a small number of providers of ESG scores has helped to standardise ratings. There is not yet an equivalent benchmark in private credit investing. The unique nature and diversity of private assets mean that managers assess this in-house, scoring each asset or company based on in-depth, qualitative research and analysis, resulting in a broad range of approaches.

Encouraging progress is already being made in some areas. For example, within social housing, the proliferation of ESG frameworks prompted concerns that the absence of a common standard for the sector resulted in ESG reporting that was incomparable. It was clear that something needed to be done to tackle the issue, and to unlock private capital to help address the UK’s housing crisis. Last year, M&G collaborated with housing associations, lenders and other investors last year to develop and launch the first common sustainability reporting standard for social housing. We are seeing collaboration around similar standards for other asset classes – the more we can do to support such initiatives, the faster we will be able to progress change.

The world requires investment on a massive scale to tackle a wide range of environmental and social challenges. Last year, the United Nations warned that the pandemic has reversed decades of progress on many issues. But there are reasons to be optimistic. While there is a lot more work to be done, investors can be at the forefront of change, and one of the best ways to do this is through private debt impact portfolios.

Specifically, the ability to focus on privately negotiated transactions and manage risk through relationships with borrowers, is indispensable in a world where institutional investors are increasingly looking not only to generate financial returns, but also to ensure that in doing so they can make a positive contribution to the planet and society.

Will Nicoll is CIO of M&G’s £67.2 billion ($92.7 billion; €78.7 billion) private & alternative assets team.