The ongoing evolution of ESG in private credit
By Anuj A. Shah, Close Group Consulting
Published: 27 June 2022
The integration of environmental, social, and governance (ESG) factors into private credit investing has gained widespread global adoption across the asset class over the past few years. Amongst both asset allocators and asset managers there has been an increased recognition that embedding an ESG analysis into the investment process helps identify and ultimately reduce downside risk.
At the same time, new issues are beginning to emerge within ESG. Biodiversity and natural capital apply to any investment that has significant exposure to physical assets. Human rights in supply chains are now being viewed as a systemic issue. And asset owners are starting to ask their managers about the impact, or outcomes, of their investment activities.
As the ESG landscape continues to evolve, and as more precise ESG information becomes available through broader and more standardised corporate disclosures, the expectations of what it means to be ‘ESG integrated’ also continues to expand and advance.
This paper (1) defines the current state of what it means to be ESG integrated, (2) examines the early stages of ESG integrated practices in private credit, (3) presents trends driving the adoption of more sophisticated and holistic ESG integration, and (4) highlights the more advanced ESG integration practices now taking root at mature state private credit asset managers.
Identifying ESG factors relevant to a business and integrating them into investment strategy, analysis, and decision making is what is now widely considered ‘ESG investing’. The assessment of ESG factors is supplemental to ‘traditional’ investment analysis and may be undertaken by a distinct ESG team or embedded into an investment team’s processes. Yet, the house view at Close Group Consulting (CGC) is that ESG integration is not binary – it’s not something you simply do or don’t do – and should be measured on a maturity scale since asset managers are at different stages in their ESG integration journeys.
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It’s important to note that the above maturity levels have been defined by CGC against industry best practices. In addition, given the dynamic nature of ESG, the expectations for the practices that underlie each stage do evolve over time.
ESG in private credit (early stages)
In the private credit asset class, there inherently is a focus on an assessment of downside risk that may affect performance because of the limited potential for upside. Within ESG, this means gaining a better understanding of the material factors that may arise during the lending period. The level of sophistication when it comes to identifying material ESG factors and the processes in place that support the ongoing monitoring of those ESG factors create a systematic ESG framework; the distinct characteristics of this framework has typically revealed a private credit manager’s overall risk management capabilities and approach when it comes to ESG. With the goal of incorporating a clearly defined and consistent systematic framework for ESG risk management, a top-down approach to ESG emerged during the early stages of ESG integration in private credit.
This top-down approach is best exemplified by an early-stage process that has been widely adopted to identify material ESG issues. The Sustainability Accounting Standards Board or SASB has issued standards that identify a subset of ESG issues deemed most relevant to financial performance in each of 77 industries. SASB recognises that “not all sustainability issues matter equally to each industry, and the same sustainability issue can manifest differently across industries”, which is why the SASB Standards were created to be industry specific. The Standards are readily available, based on evidence-based research, have included input from companies, investors, and subject matter experts, and are overseen by an independent Standards board. In short, integrating the use of the Standards is defensible and additive, and it’s therefore easy to understand why many asset managers began their ESG investing journeys by implementing the use of the Standards to identify material ESG factors.
Demonstrating a stable process across portfolio company lending opportunities has also been key to developing a systematic framework for ESG risk management. Many private credit firms have created and published a firm-wide ESG policy, deployed a governance process for the implementation of the policy, and became signatories to the Principles for Responsible Investment. The firms participate in industry initiatives related to sustainable investing and now have resources with specific ESG training and skills. In addition to identifying material ESG issues, many managers also use ESG factors to help define their investment universe, track some ESG metrics/KPIs, and provide ad-hoc ESG reporting. Taken in sum, the implementation and consistent execution of these ESG-focused initiatives comprise the framework for ESG risk management at private credit managers.
Private credit managers do, however, face several limitations when it comes to the further advancement of ESG integration within their organisations. Many of CGC’s private credit clients have remarked on the high volume of deals they need to review and how the integration of ESG factors into investment analysis cannot slow down the overall process in what remains a highly competitive market. In addition, clients have emphasised that they have limited influence when it comes to actively managing ESG factors due to the constraints presented by a) the asset class (i.e., debt vs. equity) and b) their lending period. Clients have also noted the lack of ESG disclosures by private companies.
Trends driving increasing maturity
There are a confluence of factors currently driving private credit managers to further evaluate and enhance their ESG integration practices. A primary driver is an increase in the awareness and knowledge of ESG integration best practices by asset owners/LPs, and their subsequent raised expectations, vis-à-vis ESG integration, for their asset managers. This is oftentimes reflected in the increased sophistication of ESG due diligence questionnaires sent to managers (e.g., asset class specific ESG questions).
Developments in the regulatory environment have accelerated the focus on ESG practices with investors seeking to define and document their ESG credentials more formally. In the US, the SEC issued an ESG Risk Alert in April 2021 that highlighted the variance of ESG integration practices amongst financial firms. The Risk Alert was intended to assist firms in developing and enhancing their compliance areas. At CGC, our clients have focused on ensuring that ESG workflows have been embedded into their regular governance & oversight cadence. Earlier this year, the SEC announced that ESG is one of its 2022 examination priorities, stating that it will look at whether investment firms “are accurately disclosing their ESG investing approaches and have adopted and implemented policies, procedures, and practices designed to prevent violations of the federal securities laws in connection with their ESG-related disclosures”.
Other trends driving further ESG integration include:
- increasing internal capacity of investment teams on ESG and climate
- more attention given to the impact of ESG issues on the volatility of cash flows
- the centralisation of ESG initiatives within an asset manager through the hiring of a Head of ESG and/or dedicated ESG resources to support and oversee ESG due diligence
- the availability of ESG technology tools to assist with data measurement, management, and reporting
- a desire to provide proactive proof against greenwashing
- competitive differentiation
Advanced ESG integration practices
More advanced private credit managers have integrated ESG considerations across the full investment life cycle, transitioned from a simple qualitative to a more quantitative assessment approach, defined ESG risk tolerances and parameters, and implemented ESG data management programs.
More specifically, advanced managers have moved beyond an industry-level evaluation of material ESG issues to a more precise portfolio company and business model specific assessment of distinct E, S, and G risks. This type of assessment typically includes a quantitative scoring framework (with separate E, S, and G scores as well as an overall ESG score), with the output being incorporated into the investment committee memo. This quantification and formalisation into the investment decision making process allows for comparison between investments, benchmarking, tracking, regular reporting, and an audit trail.
Distinct E, S, and G scores serve additional purposes. Advanced private credit managers use them to identify material, higher risk ESG issues to incorporate into sustainability linked loans, with interest rate ratchets based on improved performance on the material ESG issue. This aligns incentives between the portfolio company (interest rate reduction), private lender (reduced risk), and GP sponsor (value creation from improved performance on the material ESG issue). The granular view also feeds a more regular reporting of top exposures across a portfolio against risk tolerances. LPs are increasingly looking for this level of sophistication of identifying and managing ESG risks as a proxy for a manager’s overall risk management capabilities. And lastly, climate risk assessments of portfolio companies across physical, transition, and liability risk are an emerging best practice at the more advanced ESG integrated private credit managers.