Stockholm (NordSIP) – According to the National Center for the Middle Market, 200,000 “middle-market” companies – private and publically-owned firms with annual revenues between US$10 million and US$1 billion – operate in the USA. These firms employ 44.5 million workers and generate more than US$10 trillion in combined annual revenue, equivalent to a little below 50% of annual US GDP.*
If the US economy is to successfully transition towards a set of more sustainable business practices, sustainable investors cannot overlook this segment of the market. Capital Dynamics – an asset manager focusing on private equity, private credit, and clean energy.- has a new report on The Evolution of ESG in Lower Middle-Market Direct Lending, according to which “a combination of regulatory pressure and market dynamics has resulted in an exodus of commercial banks from the space,” leaving private credit funds to bridge the financing gap.
This presents ESG investors with both a material (by virtue of the scale of the middle-market) and additional (by virtue of the exit of commercial banks) opportunity to support the transition of the US economy through private lending in the middle-market. In the study, Bryn Gostin, Chair of Capital Dynamics’ Responsible Investment Committee, and Jens Ernberg, Co-Head of Private Credit at Capital Dynamics share their perspectives and insights on three aspects of responsible lending in lower middle-market credit.
Benefits of ESG criteria For Small Companies
Gostin and Ernberg cite data from a 2019 McKinsey Quarterly article, according to which the effective implementation of an ESG strategy also increases operating profits by 60%. According to a 2017 study by Cone Communications according to which 87% of consumers are likely to be more loyal to a company that support social and environmental issues relevant to them.
“Conversely, companies with weak ESG profiles face obstacles,” that present credit risks, the authors explain. “Unsustainable practices or the perception of unsafe products and services can lead to loss of customer support, legal proceedings and potentially damaging remediation expenses,” Gostin and Ernberg add.
“These businesses also have more difficulty accessing resources, may experience operational disruptions, and often have poor community and labor relations, (…) experience relatively higher employee turnover, and have limited capacity to pass through input cost increases, all of which negatively impact margins and financial performance,” the authors continue. The Capital Dynamics report also argues that unsustainable companies tend to attract greater regulatory scrutiny, and the associated penalties
ESG Underwriting Techniques for Direct Lenders
Having established the benefits of ESG for middle-market company investors, Gostin and Ernberg describe Capital Dynamics Trademarked R-Eye™ framework for underwriting ESG in private credit.
“This framework rates, on a scale of 0-5, the sustainability and risk profile of a company’s environmental, social and governance attributes by drawing on the United Nations 17 Sustainable Development Goals (‘UNSDGs’),” Gostin and Ernberg explain. The rating is also informed by information from sponsors, management teams, and company ESG specialists.
Last but not least, the authors discuss the strategic use of influence on the sponsor and borrower absent the ability to control corporate action. They contrast the influence that private equity managers have in the design of ESG policies and other sustainable issues, with the lack of such powers among private debt managers. However, the nature of the lower-middle market where Capital Dynamics operate and the asset managers reputation provide opportunities for additionality not unlike that found in fixed income markets.
“Unlike the syndicated and core-middle market, a meaningful supply-demand imbalance exists in the smaller end of the credit market, offering experienced lenders the opportunity to have a greater say in the pricing and structuring of loans,” Gostin and Ernberg say.
“Inefficiencies in our market also means that we, as critical capital providers, often have multiple weeks or months (not weeks or even days as is often the case in the syndicated and core middle-market) to underwrite a transaction, allowing us more time to analyze the ESG merits of a borrower and evaluate means to enhance those characteristics over time,” the authors continue.
“Dynamics in the lower middle market provide direct lenders in that market with the ability to have greater influence over the borrowers,” Gostin and Ernberg conclude.
* “Middle-market” seems to be a complementary term, similar but potentially non-overlapping with “Small and Medium Enterprises” (SMEs), which is a definition generally based on the numbers of employees rather than revenues.