While limited partners have long been pushing private equity firms to improve the ESG credentials of their portfolios, that attention is now shifting to private debt. But with no direct control, it is harder for credit managers to influence management behaviour, forcing funds to get innovative.

Credit managers have long worked on the basis of exclusion lists, giving their investors assurances that they will not invest in certain industries such as tobacco and gambling. Due diligence used to be about asking whether a company had broken any environmental obligations, and checking for outstanding lawsuits, but that kind of scrutiny no longer cuts the mustard.

Alison Hampton, founder of responsible investment advisor Alma Verde, says: “The biggest issue with lending is your point of leverage at the decision-making point, which is why so much of the focus for debt funds is on due diligence. Once you have made the loan, your ability to influence management is almost non-existent.”

Coralie De Maesschalck, head of portfolio at mid-market investor Kartesia, adds: “Due diligence provides the debt manager with negotiating power that is useful. The due diligence phase is critical because it is the time when we can request management changes related to ESG. It is also when we can get companies used to our reporting requests.”

As a first step, debt funds are developing sophisticated proprietary ESG questionnaires to put to management before they make a loan.

Alex Hökfelt, a managing director at Bridgepoint Credit with a focus on ESG, says: “We have developed a questionnaire that we apply to private debt transactions where we have access to management and the sponsor, trying to achieve a score on the underlying asset. That covers everything from assessing the policies in place, governance, environmental impacts and what kind of contribution the company makes to society. The output is a two-axis analysis measuring solutions and practices, designed to give us a feel for our portfolio. We have been able to do it on the majority of our direct lending assets, not all of them, but on all new deals in the past year.”

The questionnaire helps identify what is missing or needs improvement, he explains, so that issues can be raised at the outset and in follow-up meetings with management.

Leveraging relationships

Hamish Grant, deputy managing partner at Bridgepoint Credit, says it is wrong to believe debt funds have no influence at all. “We are unable, in the majority of our lending relationships, to have a contractual influence, but we do have a relationship influence,” he says. “We are not simply making a single loan for three, four or five years and then getting our money back – we are often either having to waive or amend minor terms or make follow-on loans. All of those discussions are points of influence where we can insist that any problems we have identified get fixed.”

At Ares Management, chief executive and co-founder Michael Arougheti brought in Adam Heltzer from Partners Group in March as managing director and global head of ESG. Heltzer, who previously worked at the World Economic Forum, is convinced credit funds can do more. “There is a legacy misperception that if you’re not a control equity investor, you can’t exert influence,” he says. “It’s our mission to turn that on its head in terms of how we define engagement and influence.”

“The due diligence phase is critical because it is the time when we can request management changes related to ESG”

Coralie De Maesschalck

Ares’ ESG process spans from sourcing to post-transaction monitoring and engagement with portfolio companies. When it comes to monitoring, the firm tracks ESG risks through a combination of data analytics that scan news sources and send an alert when adverse things happen in portfolio companies, and through regular interactions between deal teams and management, including check-ins on material ESG topics.

Heltzer argues that ESG needs to be about more than downside risk. “The conversation on ESG in private debt tends to focus on mitigating risk.  In our view, to only raise ESG issues when things go wrong neglects the opportunity to promote better ESG practices more holistically,” he says. “As we further enhance our own sustainability expertise throughout our company, this intellectual property is of real value to our global 500-plus borrower base. Our borrowers are feeling the pressures across a range of stakeholders to strengthen their approach to sustainability, both as an expression of corporate purpose and a means to create and protect value, but they often don’t know where to start.”

Providing incentives

The holy grail for private debt funds is to incentivise better ESG performance in companies in the same way that investment-grade issuers access sustainability-linked loans. Such mechanisms are yet to make it to the private markets, largely because small and medium-sized companies often lack sophisticated financial reporting mechanisms, let alone sophisticated ESG reporting.

Apollo’s co-head of global corporate credit, Joe Moroney, points to two deals done by Apollo in the liquid markets in the past year that provide something of a blueprint. Apollo supported an amendment to a broadly-syndicated leveraged loan for plastic packaging firm Logoplaste that will provide a lower interest rate if the company meets certain CO2 reduction criteria. It also backed Brazilian pulp and paper producer Suzano’s oversubscribed $750 million carbon emissions-linked bond, the second sustainability-linked bond to hit the market.Hampton says: “We have seen a rise in the last couple of years in sustainability-linked lending, where there is effectively a pricing differential based on ESG outcomes. The challenge for private debt is that many of the companies they are lending to are small and medium-sized businesses, below investment grade, so developing the measurable KPIs to deliver on green loans is difficult.”

Such deals are harder to do in the private markets, Moroney says. “I would anticipate that as our private debt business continues to grow, we are going to see similar incentives. Companies and private equity sponsors are always incentivised by lower borrowing costs and that mechanism will be the primary way we can help and encourage different sustainability goals.”

Moroney adds: “A lot of the challenges come down to data. It is reasonable to assume that the larger the company, the longer it will have been reporting on ESG. For a lot of our total addressable market, it is still new and they are getting up to speed. Data is a challenge for credit in general, but we are often talking about below investment-grade companies, with structural challenges that we need to overcome in order to put metrics into a credit agreement.”

Green loans still seem some way off. Grant at Bridgepoint says: “It’s a long way before we have margin cuts for tangible ESG improvement as market practice. That has been talked about a few times, but we are already seeing there’s effectively an economic focus on this.”

But, he adds: “We are looking at hundreds of transactions and prioritising capital all the time. Given there is widespread acceptance of the importance of ESG, we are always thinking about that, and that means in practice we are not prioritising loans or borrowers that present worries on an ESG front. All other things being equal, we – and other direct lenders – are prioritising good ESG stories and they are getting better pricing and better terms.”

Staying engaged

For now, the focus for many funds is on pushing the envelope around engagement. At Apollo, Moroney says: “An opportunity for us that’s aspirational is to think about ways we can hold ourselves out as a direct lender that offers financing packages to companies as well as providing them access to our ESG programme, and bring them into the broader family of Apollo companies to help them with that and really drive positive outcomes.”

While borrowers are also often engaging with sponsors on these same topics, there is an argument that the more voices asking questions, the better.

With the EU Sustainable Finance Regulation about to make it onto the statute books, and the LP community getting more vocal, this is not an issue managers can ignore.

“You only need a small part of the investor base to be very interested in this for it to be taken seriously,” says Grant. “We see the Nordic market and the Dutch LPs leading the way on this and challenging the hardest; some other markets are less interested; and in some markets there is frankly almost zero interest among investors.”

Arougheti agrees there is still a lot more to come: “In order to see change accelerate, we need to see the allocators of capital getting much more vocal in wanting to see measurable progress on ESG metrics. If there is a sense of urgency at the investor level, it will accelerate the pace of change at the investment level. The real value starts with the institutional investors allocating to more mature, more engaged ESG managers.”

One thing seems certain: ESG will be an increased focus for private debt in the months and years ahead.

Same concept, new focus?

In many ways, none of this is new, argues Apollo’s co-head of global corporate credit Joe Moroney. “I’ve been working in high-yield credit markets for 27 years and we have been doing ESG all that time, we just didn’t call it that,” he says. “The fundamental elements of ESG investing are the basic fundamental investment principles that we always look at. Now, we have to shine a more specific light on it and break it out for investors to show how we are explicitly thinking about ESG on every deal.

“Broadly speaking, this really kicked off for credit managers about two years ago. It’s about communicating the ESG diligence we always do and finding ways to include ongoing ESG engagement via the lending terms to encourage better ESG behaviour among borrowers.”