Due diligence the key to wringing ESG returns from private debt
While alternatives are occupying an increasingly greater share of asset owner portfolios, a lack of information on private companies is adding a further layer of complexity to the integration of ESG into investments.
According to Barings’s co-head of global private finance Adam Wheeler, private borrowers, because of their smaller size, are often under no obligation to collect and provide information that would enable adequate ESG assessment.
And new regulations, he said, are not likely to improve transparency any time soon.
“They won’t be required to do that even under the new [Sustainable Finance Disclosure Regulation (SDFR)] regime that's coming in in Europe,” he said.
Barings is a wholly owned subsidiary of Massachusetts Mutual Life Insurance Company (MassMutual) and manages over $382 billion of assets as of June 2021.
The challenge is particularly acute for private debt investors, where loans are made to smaller companies and where investors lack ownership rights.
At the same time, MassMutual’s head of direct private investments Phillip Titolo recently told a panel at AsianInvestor’s Private Assets Investment Week that he expects certain private debt strategies to outperform private equity over a 10-year horizon.
Aware Super portfolio manager Mike Cowell at the same event said that the fund continues to allocate capital to private debt.
According to Preqin data, global private debt assets under management grew from $573 billion in December 2016 to $1.047 trillion in December 2020.
Furthermore, 69% of Asian institutions surveyed by Preqin between the third quarter of 2020 and August 2021 are considering, or planning to, invest in private debt over the next 12 months.
STRICTER EXCLUSION CRITERIA
Lacking the ownership rights available to equity holders, and because it’s relatively more difficult to divest from private assets, private debt investors must carry out even more robust due diligence to ensure they back companies in alignment with their ESG principles, Asia Pacific head of stewardship at BNP Paribas Asset Management Paul Milon said.
“With private assets, you typically buy and hold – you make a decision that is longer term – therefore it's even more important to ensure that you mitigate the potential risks [pre-investment]” he explained.
“[With private debt] what you want to ensure is that the projects you invest in are not projects that you would not be comfortable holding all the way.”
Edwin Wong, CEO and managing partner of credit-focused alternative investment manager Ares SSG, agreed with this assessment, saying: “Given our credit strategies typically do not have the equity-style rights to influence the decision of our investments post-closing…our ESG integration focuses on evaluating companies through extensive pre-investment diligence and active monitoring during our holding period.”
While one school of thought is emerging that ESG investing is less applicable to private debt, other large asset owners are touting the benefits of an engagement-over-exclusion approach, arguing that it’s more impactful to drive change once invested in a company in need of improving its ESG credentials.
Singapore’s GIC - the city state's sovereign wealth fund - has taken this approach, nurturing private companies rather than simply dropping them.
“It is more constructive to engage and support companies in their transition towards sustainability, rather than adopt a blunt divestment approach…engagement to improve companies’ sustainability practices and focus them on a transition pathway will create long-term value,” the sovereign wealth fund said in a thought leadership piece.
A spokesperson for GIC declined to comment for this story.
MARGIN RATCHETS
A lack of ownership rights, however, can be partially addressed through margin ratchets and discounts which are specified in the loan document and lower the cost of borrowing for companies that achieve a set of pre-defined targets. A similar approach is often used in sustainability-linked bonds.
Barings is one of the pioneers of margin ratchets, according to Wheeler: “We were the first people in Europe to suggest that to two private equity firms.”
Wheeler declined to comment on the size of the reductions typically offered, but a person familiar with loan documents said that the reduction was typically between 10 and 15 basis points (bps).
“Private debt investors are typically lending at at a yield of 650bps, so this brings it down to 635-640bps,” he said.
On the targets imposed, Wheeler said, “it's not something that they should just be able to just tick off,” but rather something aspirational; for example, reporting on an indicator that it hasn't reported on in the past.
However, there are limitations to this strategy: for one, the borrower’s ability to reject the conditions.
"We can put those into the loan offer, but the borrower has to pick us to use the debt,” Wheeler said. “If you've got someone else offering the same debt facility at the same price with no ESG ratchet or reporting obligations, the owner gets to pick which debt provider it wants to use.”
Patrick Marshall, head of private debt and collateralised loan obligations at Federated Hermes, also highlighted problems of greenwashing.
"One of the immediate risks with those strategies is you've got lenders saying they’re giving ratchets for good behavior for marketing purposes.
"In effect they're doing it so they can go out into the market and say they've influenced that positive ESG change. But how do you prove the borrower wasn’t making that change anyway?”
The ability to impose ratchets may also be easier for certain debt strategies.
“In theory, [ESG integration] could be easier in special situations or in distressed strategies, where the credit provider has more leverage over the company and can add ESG conditions to the loan,” said Carmen Nuzzo, head of fixed income at Principles for Responsible Investment.
Looking ahead, Nuzzo calls for better alignment between lenders and private equity sponsors to give private debt investors greater ability to engage on ESG.
“At present, lenders have very little influence on their own, even if private companies are often highly leveraged,” she said.
Experts also expect disclosure regulation to encompass more firms as it advances.
“I think a lot of that [regulation] is going to get better, moving the obligation down the market to smaller cap companies,” said Barings’s Wheeler.