Why private debt is a better way to get companies to meet ESG goals
Companies can make all sorts of claims about their use of environmental, social and governance (ESG) factors, but unless there is someone there to hold them accountable, they can lack the incentive to follow through on their promises – which is an issue for investors who are increasingly concerned with the sustainability of assets in their portfolios.
In the early stages of sustainable investing, the burden of influencing companies to formulate and implement ESG policies was mainly shouldered by equity investors, who were the primary drivers behind the development of ESG as an investing principle.
However, there are limitations to the influence that listed equity investors can have. Even large equity funds often hold less than 5 per cent of the shares in any one listed company and therefore are entitled to only a small proportion of the votes at an Annual General Meeting where key decisions are made.
In recent years, we’ve seen a significant increase in investment in private assets such as corporate debt and this asset class has risen to the challenge of sustainable investing amid an intensifying focus on ESG among investors.
In fact, private debt has several key advantages over equities and other forms of fixed income investing when it comes to influencing companies in the development and implementation of ESG commitments:
Closer relationship with the borrower
Like equity investors, ESG-conscious private lenders can apply negative screens for activities that represent an out-sized risk to their investors, such as new oil and gas fields, or entities that operate in the coal, tar sands, tobacco, pornography and weapons industries, who contribute to deforestation or are involved in political organisations, tax avoidance schemes or the violation of human rights and labour laws.
However corporate debt funds that originate their own loans have a major advantage over equity investors in their close relationship with borrowers, from initial contact through the life of the loan, where the lender is able to set and monitor standards and KPIs for companies to achieve.
This makes private lenders uniquely placed to encourage and facilitate improvement of ESG factors across the companies they lend to. The lender’s process should involve making sure it gets the information it needs to assess ESG risk. But it also means working with management to explore how a borrower can make ESG commitments and put strategies in place to meet them.
The best corporate loan funds are applying an ESG assessment that is as quantifiable as their credit risk process and using this to drive positive sustainability trajectories across their portfolios.
A private lender engages directly with borrowers regularly to stay abreast of their progress across the material issues they face.
Private lenders are able to have regular conversations with borrowers about their ESG-related matters and the lender and borrower can work together to improve performance.
Lenders who have committed to measure their carbon footprint and set a Paris-aligned target for reducing the emissions they finance will be particularly interested in keeping tabs on their borrowers’ emissions.
Private debt also has the capacity to lend to certain industries to deliver a wide range of positive sustainability impacts. This can be done through Sustainability Linked Loans that incorporate, for example, emissions reduction, waste, diversity or health and well-being KPIs, or structured financings that are designed to attract capital to finance green or social projects.
Green Loans are loans where the proceeds are used to support environmentally sustainable economic activity, such as renewable energy, smart technology or green buildings. The proceeds of Social Loans are used to support economic activity which mitigates social issues, such as unemployment, illness or lack of education. When making or structuring loans to finance green or social projects, private lenders require information relating to the impact of those investments.
Sustainability Linked Loans may be used for general corporate purposes but contain terms designed to incentivise the borrower’s achievement of ambitious, predetermined sustainability performance objectives.
Written into the loan contracts
As private lenders, we originate the transaction, structure the terms and conditions, and control the use of proceeds – providing much more room to make an impact than in other asset classes.
When making or structuring Sustainability Linked Loans, lenders can link the pricing to ambitious and meaningful ESG objectives. They can require information that demonstrates the borrower’s historical performance against the agreed KPIs and carefully consider the proposed targets against both historical performance and independent benchmarks. Sustainability Linked Loans can include multiple KPIs, so they can drive improvement on a broad range of issues.
Private debt also affords greater access to and engagement with borrowers than mainstream syndicated lending or public market fixed-income investment.
The corporate bond sector, for example, is yet to convert the exponential growth in sustainability-linked loan (SLL) facilities in Australia into a comparable flow of sustainability-linked bonds – in large part because of the challenges of public disclosure of KPIs and details on how they will be met.
Pricing provides room for incentives
There is more room for pricing to be used to encourage ESG practises in the private debt market.
Base pricing is much tighter in the investment-grade market, and this does not lend itself to generous incentives. The private debt market has more headroom to be generous in reward for ESG progress.
However, it does not always have to be a pricing conversation that moves the dial on ESG in private debt. There are companies that need to improve their ESG performance purely because if they don’t, they will have difficulty accessing finance and capital.
Choosing the right manager
As with all asset classes, when it comes to ESG in private debt, not all investment managers are equal. Investors seeking to gain exposure to the asset class should look for an investment manager that directly originates the loans in their investment portfolio as they will have more direct oversight of borrowers’ ESG progress and more ability to influence borrowers to improve their ESG performance.
It is also important to select an investment manager that trains their lending team on ESG to equip them to better help their clients identify and address sustainability risks and opportunities and provides support through a specialist ESG team.
The focus of the investment community on sustainable investing will only increase from here. Bloomberg estimates that by 2025 one third of assets under management around the world will be sustainability themed. Investors in private debt can play a central role in promoting the adoption of ESG practices among businesses in Australia.