Private debt is still in the early stages of its ESG journey

Private debt and ESG don’t have a long history together, but there are signs of much-needed progress being made.

Long gone are the days when lenders were commonly described as the back-seat drivers in private equity-sponsored transactions. These days, debt as well as equity financiers market themselves on their ability to bring operational skills to bear, and ESG has swiftly become one more string to that bow.

Many people will have had some experience of how lenders now take green issues seriously from their dealings with the mortgage market, where a commitment to energy efficiency can be reflected in preferential mortgage rates. This reward for good behaviour has moved into the corporate lending world too.

For some lenders, evaluation of ESG is fundamental to decisions taken at the credit or investment committee level – they will contemplate withholding loans to companies that are not giving E, S and G (yes, all three – not just the E) sufficient priority. But the most common manifestation of lending engagement with ESG is in the sustainability-linked loan, and specifically the margin ratchet.

This has become an area of controversy, since there is a view that lenders have not yet achieved an optimal way of rewarding good behaviours and punishing bad. But it’s important to note that this is a relatively young and evolving area, and solutions are being found. For example, in response to the claim that a typical 10-50 basis point ratchet was insufficiently incentivising, one fund manager we spoke with this week said their ratchet was instead based on up to 10 percent of the cost of financing – which “starts to become quite significant”, according to the manager in question.

Meanwhile, a lawyer said that while a borrower being rewarded for performing well against its ESG KPIs seemed appropriate, he questioned the notion that a lender should benefit from a more favourable margin when targets are not achieved. This source suggested a better way may lie in a recent deal witnessed towards the end of last year, in which missed KPIs resulted in payments that ultimately took the form of charitable donations. Although this was a transaction that involved commercial bank lenders, the source saw no reason why it could not migrate to the private debt world (and we’d be pleased to hear of examples where it has).

These conversations are the prelude to an in-depth feature on the evolution of ESG in private debt that will be published within the next couple of months. What’s clear already is that it has become reasonably well embedded and intentions are honourable – but finding a clear way forward that provides appropriate incentives and disincentives for all stakeholders remains a challenge.

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