5 Things to Know About Leveraging ESG in Private Debt

There are clear signs that private debt is playing an increasingly important role in sustainable investing strategies. In 2021, less than 20% of general partners (GPs) and limited partners (LPs) surveyed by Pitchbook said they focused their sustainable investment efforts on private debt, which was nearly half the number of investors using public equities to deploy their environmental, social, and governance (ESG) strategies. Just a year later, the 2022 Pitchbook survey found that nearly 30% of GPs and LPs are using private debt to deploy their ESG efforts, and that figure is now comparable to the number of investors using public equities, real assets, or real estate for sustainability.

There are other signs that this asset class has reached critical mass among sustainable investors. In November, a group of leading alternative asset managers and investor associations working in the credit markets announced the launch of the ESG Integrated Disclosure Project template, which seeks to provide a standard format for ESG-related disclosures for private companies and credit investors.

Still, challenges remain. For instance, it’s difficult to utilize the same type of ESG framework used for private equity, because private debt is a more complex universe. In private debt, there are a myriad of different arrangements, including direct lending, special situations, and distressed debt, just to name a few. Lenders also have a much different relationship with management than equity owners, making stewardship and engagement more challenging, in theory, in private debt.

To discuss these and other challenges, and opportunities, ACA recently hosted a conversation between Dan Mistler, Partner with ACA ESG Advisory Services, Marie Luchet, ACA’s Head of ESG in the UK & EMEA, and Carmen Nuzzo, PRI’s Head of Fixed Income. That discussion highlighted five key things private debt investors need to know:

1. The ESG push in private debt will only speed up
   Part of this is due to the growing size of the overall private debt market, which is expected to more than double to $2.69 trillion by 2026, according to this year’s Prequin Global Debt Report. That would put private debt on track to become the second largest private market asset class, ahead of growth in private equity and real estate, Luchet noted.
   
   Another driver is the evolving regulatory environment. The U.S. Securities and Exchange Commission (SEC) recently proposed enhanced disclosure rules for investment advisers and funds concerning their ESG practices. The proposal comes on the heels of broader disclosure rules in recent years in Europe, such as the Sustainable Finance Disclosure Regulation (SFDR). “What we have seen over the last two years with SFDR gives us a pretty decent blueprint of how that might play out,” Mistler said. “But again, what the disclosures will exactly look like if anything comes into force remains to be seen.”
   
   The possibility of regulatory changes is already having some impact, Nuzzo added, as “LPs are becoming much more demanding about what they expect from the GPs with which they operate. Before they would almost give asset managers a pass. Now they ask, ‘What can you do on ESG given your level of influence and your relationship with companies? And this obviously creates a lot of potential for the asset class on ESG.”
2. You don’t need ‘skin in the game’ to drive ESG results
   Some private credit investors new to ESG considerations may assume they have less influence than equity investors in terms of stewardship because they lack an ownership stake. But in some ways, private debt investors may have more leverage than they assume, including on ESG issues, because of the bilateral relationship between lenders and borrowers.
   
   Private debt investors understand their leverage is imbedded in the loan contract, Mistler said. And the way those contract terms are agreed upon will depend on what you’re seeking to achieve, he said. “If you’re after ESG performance to serve the performance of the loan and enhance risk assessment, that’s one thing,” he added. “It’s different if you’re an impact-focused investor after ESG performance to serve another outcome as well as the performance of the loan.”
   
   Not surprisingly, when ACA polled attendees during the webcast about their organization’s biggest ESG challenges, few considered “stewardship or engagement with portfolio companies” as a substantial roadblock when it comes to implementing ESG. “This is what we see on the ground as well,” said Nuzzo. ”I’m really kind of heartened by the fact that stewardship is not being seen as a main barrier because we really encourage our lenders to be more engaged and not to use the fact that they’re not shareholders — not having skin in the game — as an excuse. Private debt investors can play quite a big role.”
   
3. In private credit, ESG performance can be directly linked to borrowing costs
   For instance, borrowers may contractually receive a discount if they hit a sustainability performance target, or they might get a small penalty if they fall short of what’s stipulated in the agreement, Nuzzo noted. These conversations between lenders and the management team may start with a singular goal, like reducing one’s carbon footprint, but it often expands beyond that. “You may target a reduction in your carbon footprint, or an improvement in the staff ‘health and safety” Nuzzo said. “Are you trying to create a more inclusive culture? Then you can build that into the loan right from the beginning as you risk the asset and then reflect that in the pricing.” This makes private debt a particularly exciting space to watch from an ESG standpoint, she said. “We're seeing a lot of activity in Europe, less so in the U.S. but there is space for this to grow globally.”
4. Debt investors face greater challenges in obtaining ESG data
   Attendees of the webcast did raise some concerns about their ability to obtain high-quality ESG data. Part of that has to do with the sheer number of privately held businesses that private debt investors work with. But it also has to do with the nature of private debt.
   
   Nuzzo points out that private lenders “are the ones who face the biggest challenges in terms of data collection because they're dealing with the mid-market segment, small- and medium-sized companies that either are too small to have enough resources to produce the data that investors now expect, or they don't even understand why investor expectations are now changing.” Complicating the growing need for data is the fact that there are several competing ESG reporting frameworks to adopt. “The standardization in data collection is really key,” Nuzzo said. “I don't think we'll ever get to a stage where there will be just one way to report, but at least we can work towards a minimum common denominator.”
   
   That said, investors understand that they can't hide behind the data-access challenge to not incorporate ESG, Luchet noted.
5. Private debt investors have options for gathering data
   “One of our main pieces of advice is to negotiate with your data provider,” Mistler said. “There's so many data providers that are very big, and as a result, they’re less interested in negotiating with small players.” Ultimately, what’s needed is for those data providers to be willing to extend coverage. “You need them to cover new issuers, new names, smaller names to build out their databases so they can have better benchmarking products,” Mistler said. For those who aren’t interested in negotiating, he noted “there’s a world of new and interesting data providers out there all coming up very quickly to solve a lot of the very problems that are facing private investors, especially private investors with instruments like debt.” One of the top reasons for ACA’s recent acquisition of Ethos ESG is its ability to provide ESG ratings and benchmarking for private companies.
   
   Also, keep in mind that you’re not in this alone. Another strategy, Mistler noted, is for private debt investors to recognize the other types of providers who are part of the same transaction. “You may be providing debt, but there may be equity providers (in the deal) that are engaging already on ESG, and I think you can benefit a lot from what they have already done or are doing.” Mistler calls this “collaborative engagement,” and it’s a tool that he sees debt clients use to address concerns about not having enough leverage or information.

How we help

The ESG landscape is evolving at a rapid pace and requires additional resources to meet investor and regulatory expectations. Our dedicated ESG Advisory and Analytics practice helps private credit firms of all sizes develop and manage ESG programs and monitor private loan portfolios.

Through our acquisition of Ethos ESG, ACA’s portfolio monitoring solution now offers private company ratings and analytics in line with SASB, SDGs, and other frameworks, as well as custom-selected peer benchmarking and carbon estimates, all without direct engagement with the portfolio companies, if that is not feasible/desired.

For questions about this article, or to find out how we can assist with your ESG data, please reach out to your ACA consultant or contact us.

Watch our webcast on demand

As global investments in private debt continue to expand and play a greater role in investment strategies, so too does the interest in the ESG aspects of these investments. However, because of a lack of regulatory clarity around private debt, and the nature of these investments, investors struggle for leverage, access to ESG data, and to find sources of influence on ESG matters. This webcast discussed the integration of ESG in private debt.

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