Stockholm (NordSIP) – At a time of compressed yields, many fixed-income investors have turned to private debt markets to find more profitable investment opportunities. The trend is echoed among sustainable investors, which have sought to increase the ESG profile of private debt markets to meet their needs.
To understand the considerations at play, NordSIP organised a webinar on the topic on April 14th. The event brought together Cecilia Sköld, portfolio manager Skandia Life Insurance, Laura Vaughan, Head of Direct lending at Federated Hermes, Thomas Lane, Fund Manager at M&G Investments, and Lea Vaisalo, Head of structuring and private credit external products at Nordea Asset Management.
ESG in Private Debt Markets: On the Rise
At Skandia Life Insurance private debt is a growing asset class, according to Sköld. “We have invested in private debt for a long time, but it really started picking up after the financial crisis when we saw a good risk-return opportunity. Our main allocation is to leveraged loans, but also subordinated debt strategies and direct lending with a European focus,” she says. There has been a clear increase in ESG integration in private debt markets recently, Sköld also observes.
To Vaughan, ESG integration means taking sustainability into account throughout the whole private debt chain. “ESG doesn’t just stop once you make the loan. It’s integrated from day 1 until the loan is repaid,” she points out, highlighting sectoral exclusions, minimum ESG borrowing hurdles, continuous monitoring of ESG factors as examples of this process.
“ESG continues to mean different things across our diverse asset management client base,” Lane says. “Week by week, clients are moving up the spectrum. The range of views is narrowing from the bottom up, moving up from financial holding objectives to a more ESG-integrated and sustainable approach.”
“We consider sustainability risks in all the investments that we do, whether it being a commitment to managers or co-investment,” Vaisalo notes, describing how her team integrates ESG factors. “The closer we are to the source of the investments, the more detail and data we can get. For managers, we have a general questionnaire, and we always do our own internal ESG rating and an annual review process. For co-investments, we work very closely on a case-by-case basis with our responsible investment team to define the relevant questions and measures to incorporate in the risk and credit analysis. We can be a lot more specific in terms of the types of questions that we ask.”
The Pros and Cons of Regulation
“The purpose of [EU’s Sustainable Finance Disclosures Regulation, SFDR] is to increase transparency in the market and minimise greenwashing,” Vaughan says. “I think it will have that impact because the requirements for the ESG fund and for the manager are going to be quite complex. Someone who does not have a high ESG conviction, the in-house resources or the knowledge on how to bring their fund up to speed is not going to bother. That will make the market simpler.”
“We are launching our next strategy in a couple of weeks and we would hope for it to be an Article 8 fund, that is an ESG-integrated fund. As you go into Article 9 and 10, you are looking at a thematic and impact investment,” explains Vaughan. Confident as she is of her firm’s ability to meet the milestones, she also expresses some sympathy for smaller companies. SMEs will certainly encounter difficulties when reporting on Scope 1, 2 and 3 emissions of a borrower as they are not gathering this information at the moment and the cost and the resources needed for them to do so would be quite onerous. “There´s still quite a lot of work to do to get everybody up to speed. What you don’t want to do is exclude those funds merely because they couldn’t obtain the data.”
Lane agrees with Vaughan. “Across our range, and particularly within the leveraged finance group of funds, we classified the majority as Article 6. We have a robust ESG process that applies at the issuer level for all mandates within that range. A couple of funds were able to go further and be classified as Article 8, as a more deliberately sustainable type of mandate, either through ESG-sector screens or through a best-in-class approach, such as the sustainable loan fund that we are looking to launch in a couple of months.”
“Given the present data standards we have in the market, it is quite difficult for a private debt fund or any type of private asset manager fund to be more than an Article 6 fund according to SFDR. Direct investments are easier to set guidelines for and be an Article 8 or 9,” Vaisalo argues. “When you have legacy assets it becomes very difficult to adapt to new regulation. We would love for all our funds to be at least an article 8, but it is not realistic at the moment. We don’t want to exclude investments only because of the data. We are making sure that we have a thorough process to assess the ESG safeguards.”
Where Size, Scale and Resources Actually Matter
“Size, scale and very well-established relationships are essential to make sure you can see all the deals that are available. If you can see everything you can be selective. In the loan space where you typically decline 60% of opportunities that you are shown in any given year when you start overlaying ESG screens that will narrow your investment universe,” Lane says.
“It is incredibly important to be well resourced. Proper ESG analysis, integration and engagement take a lot of time. I have also found that our responsible investments team have been extremely useful at sitting above the asset classes – debt, equities, real estate, public or private – they’ve been able to take the best practice from each market and overlay their own expertise and leverage the lessons learned from one sector to another,” he continues.
For Vaughan, a strong origination pipeline is key for sustainable private debt asset managers. “We have four legally binding origination agreements with partner banks in our core geographies – the Nordics, Germany, the Benelux and the UK. Every time our partner bank originates a deal, they have to introduce it to us,” Vaughan explains. “That means we are seeing between 400 and 500 deals a year. We are looking to select 5%-10% of those deals at the most. We have the ability to walk away.” A manager without the luxury of such a strong origination pipeline might just have to overlook certain ESG consideration, according to her.
Recently, Vaughan’s team considered a deal involving a debt collection company, she recalls. Although the initial concern was that the employees’ payment scheme might incentivise aggressive techniques, the actual red flag for Federated Hermes came when £1.5 million of overpaid fines, which originally sat in a ringfenced account, was transferred to the company’s current account. When Federated Hermes raised this issue, they were told that auditors had merely warned the company ‘not to do it again’.
To Vaughan, this attitude “rang governance alarm bells and we just had to walk away from it. [We can do that] because we know we can decline and with all the deals that we are seeing another one tomorrow, whereas someone who is not originating enough might just say, ´well maybe it was a one-off’. Then you are taking your investors with you into potentially risky assets. Origination is key.”
Carrots or Sticks?
Discussing the trend of introducing of ESG-related targets in private debt documentation, Vaughan notes that there are two possible approaches, the carrot and the stick. The carrot tends to come increasingly in the shape of an ESG margin ratchet. But for Vaughan, this approach may not always work. “If you are offering 5-10 basis points for a borrower to improve some ESG characteristics, it’s not enough. First of all, the improvement is optional. Moreover, there’s no way of knowing that they weren’t going to do that investment anyway. You need to be careful that the asset manager is not greenwashing a little bit by overinflating what they are achieving.”
“The stick approach, which I would prefer, is to agree with management upfront and incorporating your enhancements and requirements into the loan documentation on day 1, giving the borrower a timeframe for achieving these goals. If they fail to achieve these targets, then it’s a default,” Vaughan says. “That might sound harsh, but on day 1 the managers and the owners buy in and everyone is in agreement. In that situation, everyone is very incentivised to get things done because no one wants to declare a default.”
“We had a Swedish road-markings business that was making an acquisition and the ESG standards and health and safety of the company that they were acquiring were just not up to the level we wanted them to be,” Vaughan explains. To resolve this issue Federated Hermes came to an agreement with management regarding what they needed to achieve in the first 6 months which was detailed in the loan agreement, which the company was able to implement successfully and on schedule.
Although Lane agrees that there is still much room for improvement regarding ESG ratchets, he is keen to point out that they sometimes move the needle in the right direction. “[Including ESG ratchets] does deliver some information and encourage disclosures. But it also brings the issues to the forefront of management’s mind and helps bring the pertinent issues up the agenda.” However, the introduction of these targets needs to be there from the beginning rather than come in as an afterthought. “The related KPIs should be clearly stated from the onset, they should be relevant, and they should be stretching,” he adds.
Getting the Facts Straight
Data availability for private debt has improved over the last couple of years, according to Sköld. “The awareness of integrating ESG aspects and promoting sustainability factors in private markets has really exploded. I can see the change in comparison with 2013 when I joined Skandia, both from a bottom-up perspective when we invest in companies, but also when we evaluate ESG at the external manager level.”
To get more information, Skandia sends a responsible investment questionnaire whenever it considers investing with a private debt manager. Managers get a score and if Skandia decides to invest, annual updates will be requested, and improvements are expected to take place over time. Dedicated annual ESG-focused meetings with managers will ensure that these considerations are taken seriously. “We also include ESG language in the legal documentation to secure a minimum level of ESG integration in the strategies we invest in, and alignment with Skandia’s views,” Sköld adds.
“In the Nordics, even small managers have dedicated ESG resources. If you believe in the circular economy and its benefits, then it is worth for the business to invest in that [resource], whether large or small,” notes Vaisalo. Having a dedicated ESG team, however, will not suffice unless they are invited to the table. “If the ESG team is integrated into the investment process we can see that in past investments decisions. However, if the ESG team is ignored, that’ll show,” she continues.
United Against Greenwashing
Discussing how asset managers and asset owners can avoid greenwashers in private debt markets, all of the panellists agreed that the focus should be on due diligence, transparency and engaging with investment opportunities.
“Avoiding greenwashing is just about asking all the questions, doing the due diligence and getting concrete examples,” Vaughan says. “I would also be looking at the wider picture. What is the conviction of the entire firm? Is this one stand-alone fund that they’ve decided to [create] to ride the wave of impact or is there buy-in from the firm as a whole?”
For Sköld, the ambition level of the manager is fundamental: “What resources have they dedicated to this? The really important idea is to fully understand what the manager has invested in and what they have decided not to invest in.”
“Transparency and cooperation between asset managers and asset owners are key. No one has all the answers from day one, especially not in private debt,” Lane concludes.
