Private debt firms face an array of ESG challenges

A rapidly changing ESG landscape faces market participants, says ELFA’s Sabrina Fox.

The increased focus on ESG in the private debt market is clear, with significant developments in regulation, lending terms and data disclosure demonstrating the strong trajectory toward ESG adoption among market participants.

The regulatory landscape is changing rapidly. As such, direct lenders are working hard with advisers to determine their approach to implementing applicable regimes, including the EU Sustainable Finance Disclosure Regulation. The full text and implementation methodology is expected this July.

According to our recent ESG in Private Debt Survey of lenders, two-thirds of respondents believe they are in scope for SFDR, and a majority of what would now be classified as Article 6 funds have plans to shift to Article 8.

ESG is also increasingly making its way into contractual terms in the private debt market. Due to challenges with ESG data gathering, many investors are including ESG reporting covenants from borrowers, in particular due to requirements that the EU SFDR places on lenders to report this information.

Further, many private debt investors are incorporating provisions into their agreements to incentivise sustainability at the borrower level. Currently, the standard approach to incorporating ESG in private debt is to link sustainability provisions by way of key performance indicators and sustainability performance targets relevant to the specific business of that borrower to margin ratchet provisions. This will cause the cost of funding to go up or down depending on whether the SPT is met.

The direct relationship between lenders, borrowers and their owners facilitates collaboration and the ability to establish KPIs and SPTs after a deal closes. This gives the asset class an opportunity to select terms uniquely tailored to the sustainability objectives and potential of the underlying business.

Integration challenges

However, there are challenges to ESG integration. Lenders have found ESG data to be lacking during initial due diligence phases; third-party data providers tend not to cover private credit borrowers; and post-investment ESG monitoring can be challenging, in particular where management teams are still developing their ESG data collection and disclosure processes.

While increased engagement by borrowers and private equity sponsors is encouraging, with some showing willingness to provide ESG information, the lack of data is exacerbated by borrowers’ nascent data collection and reporting methods. This is in part due to the fact that the typical private credit borrower is usually a smaller business than those issuing public equity or fixed-income instruments.

“Lenders have found ESG data to be lacking during initial due diligence phases”

Our survey of private debt lenders also highlighted the need for greater standardisation in disclosure on ESG topics. To support greater standardisation and to provide guidance to borrowers on disclosure and engagement, ELFA has published sector-specific ESG fact sheets setting out the material ESG topics that lenders would like to see. Following workshops with nearly 60 borrowers and dozens of credit analysts, the series now covers 14 different sectors, and includes a sector-agnostic General ESG Fact Sheet.

To counter these challenges, ELFA has created a working group to examine how to increase availability of ESG data in private markets, and we are updating our Guide for Company Advisers to ESG Disclosure in Leveraged Finance Transactions to include a chapter on private debt.

By way of these and other collaborative efforts, including the ESG Data Convergence Project and the recently announced efforts of the Loan Syndication and Trading Association, Alternative Credit Council and the Principles for Responsible Investment, the private credit market will no doubt continue to grow in its approach to ESG.

Sabrina Fox is chief executive officer of the European Leveraged Finance Association