Private equity may have been quicker off the ESG starting blocks, but private debt is catching up fast.

“It used to just be private equity sponsors that were driving the agenda; portfolio companies had the option to say they didn’t want to implement certain initiatives and private debt investors were more dependent on the sponsor to effectuate change,” says Adam Heltzer, global head of ESG at Ares. “Today, that is no longer the case.”

However, given that lenders – unlike sponsors – lack board seats in portfolio companies, what levers do they have at their disposal?

The rise of sustainability-linked loans over the past 18 months (along with the new principles published jointly by the Asia Pacific Loan Market Association, the Loan Market Association and the Loan Syndications and Trading Association in the summer of 2021) has helped focus minds on what lenders can seek to achieve in this area.

“Sustainability-linked loans are a very powerful tool for addressing climate change and ESG more generally,” says Coralie De Maesschalck, head of CSR and ESG at Kartesia. “Most are linked in some way to climate and are based on the achievement of pre-defined KPIs. I firmly believe this is the way to go and will be a significant part of how private debt can take action on the environment.”

Their adoption has certainly been rapid during recent times. “There has been a strong development in the market of sustainability-linked loans in the past year or so,” says Thierry Vallière, head of private debt at Amundi, adding that this is evident in the firm’s own investment pattern. “Pre-crisis in 2019, these made up around 15 percent of our deals; in the year to date, around 35 percent of the transactions we’ve done have been sustainability-linked and next year, we expect this figure to rise to 50 percent.”

Moving up a notch

The creation of a market for sustainability-linked loans has led to the development of ESG ratchets in loan documentation. It’s a movement that only really started to take off in 2020 but has gained significant momentum this year.

Ares, for example, funded the largest private debt-backed sustainability-linked loan for environmental and engineering consultancy RSK in the summer, providing £1 billion ($1.35 billion; €1.2 billion) in direct lending. Margins for the loan are linked to the achievement of targets around reducing carbon intensity, as well as health and safety management and ethics improvements.

“ESG ratchets are an incredibly exciting tool and a massive step forward for private debt investors,” says Heltzer. “Just two to three years ago, the industry standard was negative screening; now ESG is in the documentation and lenders can engage in a dialogue with borrowers to help support them in aligning rachets with their ESG goals.” He points to RSK as an example and adds: “This type of work is light years of progress in a very short space of time, but there is still a lot more to do.”

“This year, for the first time, we have a set of data around carbon footprints that we can rely on”

Stephan Caron

Yet while there is a great deal of excitement about the potential for ESG ratchets, there are some concerns. Setting targets at a meaningful level is one of these. “It’s a competitive market for deals,” says Vallière. “But as an investor, you have to pick the right companies to back and be able to establish the right targets. You need to avoid greenwashing – you can’t just set targets that simply hit what’s already required by regulations. We do see some sponsors do this. The issue for them, of course, is that we have the same investors. If they care about climate and ESG, they’ll notice who these sponsors are.”

Laure Villepelet, head of ESG at Tikehau, agrees: “Some managers do attempt to negotiate terms that are just business as usual, such as disclosing carbon emissions, which they might need to do anyway. We see our role as challenging them to go beyond this.”

The other issue is establishing ratchets that actually provide an incentive for change. De Maesschalck explains her firm’s approach: “We spent a lot of time with consultants and peers to determine how to make these ratchets meaningful. Our view is that a discount as opposed to a penalty is the most effective structure for us, as we want to be seen as a partner rather than a policeman.

“The discount also has to be significant – in the range of 25bps to 50bps. It’s clear that when you reach that kind of level, you are not greenwashing and you are offering a meaningful incentive for change. If you select the right KPIs and the company achieves the maximum discount, she says returns will benefit from the value you create.”

Trial and error

Few expect to get this right all the time, especially as these kinds of structures are in their infancy. However, there is an expectation that the situation will continue to develop rapidly. “Given the amount of progress the industry has made over the past two to three years, we have to be OK with trial and error and experimentation when it comes to target-setting,” says Heltzer.

“This is only the beginning and as an industry we will learn a great deal over the coming 12 to 18 months about where we’ve set targets that are too ambitious and where they haven’t been ambitious enough. In two years’ time, there will be a lot more sophistication around this.”

It’s a view shared by Stephan Caron, head of European mid-market debt at BlackRock, who sees the capture of – and ongoing improvements to – data as a vital ingredient to setting targets and then pushing for change. “ESG and climate change have moved to the centre of the agenda and the availability of better quality data allows us to measure how our portfolio companies are progressing in a way that wasn’t possible before. This year, for the first time, we have a set of data around carbon footprints that we can rely on – we see this now as year zero. All this makes ESG ratchets more relevant – without data, they would be meaningless.”

Yet ratchets are only part of the story. Even without board seats, private debt players are increasingly recognising that they can influence the direction of travel in other ways. “Offering the option of cheaper financing can be very useful,” says Vettaseri. “But soft power is vital if you really want to bring people along with you and create cultural change. As debt providers, we really need to make the case that ESG is win-win. People often underestimate the power of the whole package.”

Caron agrees: “When we negotiate terms, we can add undertakings around climate change and introduce ESG ratchets, but that on its own isn’t sufficient. We have to encourage change by supporting GPs and borrowers.”

At times, that might mean taking a longer term view, adds Vincent Lemaitre, head of ESG, private debt at Tikehau, who also emphasises the need for support and education. “We engage with clients not only at the outset, but through the entire lifecycle of our investment,” he says.

“We have an ESG expert dedicated to each of our business lines, which allows us to share best practices and improve processes. Importantly, rather than telling companies they have to decarbonise, we can support them by explaining how this can be achieved.”

This can mean that not everything falls into place straight away, but it can eventually lead to improvements. “We don’t always necessarily get what we want immediately from discussions, but we focus on playing the long game,” says Lemaitre. “We recently received an ESG thesis from a sponsor that we felt didn’t go far enough. While we didn’t get the changes we were seeking, the client is now aware of what is out there and what can be achieved so that more progress can be made when we next engage with them.”

There is no doubt that private debt has been on a steep learning curve when it comes to pushing for positive change around ESG. Yet it’s also apparent that the developments we’ve seen to date are just the beginning. “I’m convinced that, five years down the road, everyone will have incorporated ESG into their financial analytics,” says Vallière.

“When assessing a company, we’ll look at leverage and cashflow, but we’ll also take ESG ratings and practices into account. And at some point, no-one will be willing to finance companies with poor ESG ratings or practices.”

This article first appeared in affiliate publication Private Debt Investor