ESG Integration in Private Debt

Below, the various approaches of Sustainable Finance applied to Private Debt are described.

Negative screening

Prior to the deal, asset managers can apply a negative screening, which corresponds to the exclusion of potential borrowers on ESG criteria, such as: 

• Exposure to controversial activities and sectors (weapons, tobacco …).
• Norm-based or controversy exclusions: companies that do not respect international standards and principles, such as Human Rights, or that face controversies. As a reminder, a controversy is defined as an event that has negative impacts on sustainability factors, such as societal, social or environmental factors.

Should the asset manager have an exclusion policy, the negative screening applied shall match the policy’s exclusions to the least but can also be extended. Negative screening is a standard market practice that contributes to reducing exposure to sectors considered as risky: it can also be a means of addressing sustainability risks identified by the investors, as required by SFDR.

ESG Screening: assessing the ESG performance and/or apply positive screening

ESG screening corresponds to the systematic collection of ESG data, for various purposes. It can then be used by the asset manager to apply an additional layer of selection, based on the achievement of ESG targets or minimum ESG requirements. The data collected during this initial ESG assessment can also be used by the asset manager as the basis for dialogue or to identify areas for improvement.

It requires developing an ESG assessment methodology, to conduct ESG due diligence with pre-determined thresholds. When developing an in-house methodology, the investor can tailor the assessment conducted, deployed with tools such as an ESG questionnaire and dialogue.

A major benefit of developing an in-house methodology lies in the opportunity for the investor to focus on issues and topics which are the most material and relevant to them. However, it reduces the market homogeneity regarding ESG assessment as each investor develops its own analytical framework. The same company can thus have a different level of ESG performance according to the investor’s interests, concerns, and main focuses.  Positive screening can be challenging for this asset class as a result of the lack of publicly available and homogenous information, the lack of data collected by potential borrowers, and a lesser level of maturity as regards to ESG and sustainability compared to listed peers.

During the holding period, a similar ESG assessment process can be applied. The investor’s approach then consists of accompanying borrowers to improve their ESG performance.

Monitoring the ESG performance

ESG Integration can also involve the monitoring of ESG performance through the deployment of an ESG questionnaire, which can be a similar or the same as the one used to conduct the ESG Due Diligence or the initial ESG assessment

Conducting ESG assessments requires the investor to develop an in-house assessment methodology or to externalize it with experts, tailored to its needs and topics of interest, as well as to the type of actors that is being assessed.  Below, a non-exhaustive list of elements to be kept in mind in order to design an ESG questionnaire:

By asking borrowers to measure their performance and report it through a questionnaire, lenders contribute to enhancing the borrower’s awareness of ESG-related issues. Furthermore, the ESG assessment is also the tool that will enable investors to collect the data for reporting or compliance requirements. Indeed, funds classified as article 9 or funds managed by asset managers above the size threshold defined by SFDR are compelled to report on the Principal Adverse Impacts of their underlying investments. The PAI indicators can thus be integrated into the ESG questionnaire.

ESG-terms integration in loan documents

Investors can integrate ESG-related clauses in the lending terms and documents. An ESG clause can be a major leverage of ESG integration as it offers an opportunity to engage the parties on ESG from the inception of the transaction. The clause should enhance the ESG commitment of the borrower and can integrate various elements, such as the discussion of ESG topics at Board meetings, mandatory reporting on specific KPIs, and monitoring, and improvement of pre-determined criteria, designed and agreed upon during the deal settlement.

Integrating an ESG clause into a contract can also consist of requiring the borrower to respond to an ESG questionnaire at a predetermined frequency. The clause incentivizes borrowers to communicate and assess results while raising their awareness on these issues.

Dialogue

Dialogue is the equivalent of active ownership applied to debt and is key to building trust with borrowers. Dialogue can promote ESG topics in order to raise awareness and improve the ESG performance of borrowers. This lever for action is relevant for direct lending only and not for syndicated loans.

Dialogue can offer qualitative insights into management’s sensitivity to and awareness of ESG-related risks and issues, which cannot be grasped through quantitative ESG due diligence. It provides additional information for the investment decision, in the pre-deal phase. It also demonstrates interest in ESG topics to the potential borrower, in a context of competition among lenders.

During the holding period, ongoing dialogue can be conducted on ESG-related topics. Should ESG assessments be conducted, the results can be used as a basis for dialogue in order to analyze the potential improvements that can be achieved as well as the ESG risks identified. Dialogue can also be leveraged to discuss events, such as controversies, that might occur and which could be of significant ESG relevance with financial or ESG impacts.

Measure outcome and report

Beyond the analyses conducted for ESG integration purposes, there should be strong emphasis put on ESG outcome measurement and reporting. The growing pressure for disclosure is the result of the demand for accountability and transparency, arising from civil society, institutional investors, and regulators.  Reporting needs to provide information on the ESG strategy adopted, the objectives and resources dedicated to achieving the objectives, and the sustainability outcomes and results.

3. ESG integration in Private Debt offers opportunities for financial innovation

Private Debt appears to be an asset class for which there is plenty of possibilities for financial innovation, within financial products themselves but also to disrupt traditional collaboration and business practices between stakeholders. Below, two examples of innovations are described, the prior being the impact-debt mechanism, also referred to as ESG-linked loan, the latter being the potential of coordination with Private Equity Sponsors, an innovative market dynamic.

Impact-debt mechanism or ESG-linked-loan

Among the impact debt mechanisms, a growing market practice consists of incentivizing borrowers to improve their ESG practices through the implementation of ESG-related reductions in the cost of debt through a margin ratchet mechanism.

The potential lender conducts an ESG assessment prior to the investment and identifies Key Performance Indicators (KPI) that are material to the borrower and that need to be improved – the number of KPIs can vary according to the lender’s expectations or the borrower’s maturity.

For each KPI, the lender and the borrower agree on a target to achieve within a determined time horizon. The targets have to be ambitious yet achievable, material, and consistent with the investor’s ESG goals.

The achievement of the ESG target(s) is associated with a capital cost reduction. The more criteria the company meets, the larger the cost reduction. The KPIs are monitored and reviewed annually. The lender can also apply a penalty if a target is not achieved.

Benefits of these mechanisms

• In a market with fierce competition between investors, impact debt can give a competitive advantage to the lender, who demonstrates interest in extra-financial issues.
• Determining the KPIs and monitoring them fosters dialogue and incentivizes the borrower to collect ESG data.
• The incentive is strong for companies, which creates a favorable context for them to achieve their goals.
• The cost reduction corresponds to a lower exposure to ESG risk: the risk/return ratio is close to stable.

Risks associated with this mechanism

• As the market is highly competitive and prices low, a margin ratchet mechanism might lower already low prices.
• The difficulty lies in defining targets that are ambitious and require efforts from the borrower to achieve them but have to be reachable and consistent. Too easy targets to achieve expose the exercise to “impact-washing” criticisms.

Coordination with Private Equity Sponsors – creating new market dynamics

Lenders can coordinate with Private Equity Sponsors when it comes to ESG-related topics. This coordination can apply at several levels and take different forms, ranging from a more operational collaboration to a more strategic one, as illustrated in the figure below.

Outlooks for ESG Integration in Private Debt

The greatest challenge for Private Debt is access to data. Indeed, despite the resources available for ESG research purposes (desk research, third-party providers, technical experts, legal due diligence documents, co-investors, ESG questionnaires, and dialogue with management), there is a great difficulty to collect relevant ESG data, which can be explained by several factors:

• Borrowers do not systematically track their ESG impacts and therefore do not have information – this is likely to become less of an obstacle with regulation introducing more requirements and extending the scope of application of mandatory non-financial reporting. The Corporate Sustainability Reporting Directive (CSRD) indeed broadens the scope of mandatory reporting as opposed to the Non-Financial Reporting Directive (NFRD) due to the lower size thresholds.
• Companies are solicited by several investors to respond to their ESG questionnaires. As ESG questionnaires vary from one investor to another, filling them in becomes a burden for companies, leading to them not responding.
• There can be a mismatch between the data collected by the borrower and the data required by the lender. This is likely to become less of an issue with the introduction of the CSRD and entry into force of the European Single Access Point.

There is a lack of public reporting obligations for non-listed and small companies and therefore a lack of available data. This challenge can be partially overcome with the development of internal capacity to gather ESG data, such as ESG questionnaires which comprise quantitative and qualitative questions, or through market initiatives that foster homogeneity in ESG data collection.

The forthcoming regulation and the entry into force of CSRD are likely to ease the access for investors to ESG data, as companies will be compelled to disclose standardized ESG metrics and data. The growing regulatory constraints on disclosure as well as the fund classification introduced by SFDR also contribute to enhancing market transparency, especially with regard to ESG.

Overall, the Private Debt market has a fast-paced evolution, especially for ESG-related concerns. The constant financial innovation, the growing demand from borrowers for support in the implementation of CSR strategies and non-financial support as well as the market’s scrutiny and expectations on ESG integration contributes to rendering this asset class a perfectly well-suited one for ESG integration, in spite of the data constraints it faces and the regulatory uncertainties.

Conclusion

To conclude, despite the complexity and variety of tools at the disposal of Private Debt investors, this asset class seems to be very well suited to foster a higher level of ESG integration. Indeed, it offers a new area for innovative practices which will be supported by an always more demanding regulation.

Data-related constraints are likely to become less challenging with the entry into force of CSRD and the increasing capabilities of financial actors, who tend to be often equipped with modeling tools or accompanied by independent experts. Also, borrowers are likely to become more familiar with ESG data monitoring and collection, which will contribute to smoothening the exercise.

Footnotes:

[i] Private markets rally to new heights (2022), McKinsey Global Private Markets Review 2022, https://www.mckinsey.com/~/media/mckinsey/industries/private%20equity%20and%20principal%20investors/our%20insights/mckinseys%20private%20markets%20annual%20review/2022/mckinseys-private-markets-annual-review-private-markets-rally-to-new-heights-vf.pdf