Finding Leverage - How Debt Investors are Tackling the Challenge of ESG

With an abundance of optimistic growth projections centered around credit markets, 2021 is predicted to be a banner year for portfolios weighted in private debt.  Couple this projection with a growing global recognition of the need to embrace a transparent commitment to ESG criteria within an investment portfolio, it seems an easy step to combine private debt investments with ESG commitments to land on a high-performing, socially and environmentally sound investment strategy.

But just how easy is it to incorporate ESG criteria into a private debt portfolio?  

In a world that is working to evolve how the finance industry defines accountability in terms of environmental, social, and governance metrics, what tools does a private debt-based portfolio manager have to create an incentivizing framework to promote implementation of ESG-related principles, policies, or even benchmarked reporting across their suite of investments?  

ESG precursors to private debt

Implementation of ESG-related principles as a leveraged component in the debt structures of a funding mechanism is not necessarily novel. Take, for example, large infrastructure projects, which are subject to a range of unique ESG risks and opportunities due to their scale, relatively long lifespan, and potential for promoting socioeconomic growth and development. Since projects of this nature are often financed via non-recourse project finance arrangements whereby lenders look to the earnings of the project for repayment, lenders have a vested interest in the performance of the project, and in the environmental, social and reputational risks that could affect such performance over the lifetime of the project. 

As such, lenders have been imposing ESG requirements in project finance agreements beginning in the 1990s, with rapid development of various environmental and social risk management frameworks in the 2000s. The Equator Principles (EPs) and the IFC Performance Standards, which are embedded within the EP framework, are among the most widely applied. 
Financial institutions that elect to incorporate EP governance into their financing structure are certified as Equator Principles Financial Institutions (EPFis), committed to only financing EP-compliant projects. As of July 2021, there were 118 EPFIs in 37 countries, including major U.S. lenders such as Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo. 

Much success has also been seen in the fixed income market through development of green bonds.  First issued by the World Bank Treasury in 2008, green bonds, also known as climate bonds, provide a dedicated funding instrument to promote the development of climate-related projects.  The green bond product evolved through collaborative efforts between the finance and scientific communities and envisioned an inclusionary approach to facilitate investment in environmentally sound projects within a traditional investment portfolio. 

These investments are guided by the Green Bonds Principles (GBPs), which provide the overarching framework to step issuers through the bond certification process.  The GBPs also incorporate an impact reporting process to further facilitate project transparency and allow both the investor and the local community to see the impact of the investment. 

Green bonds are often tax-incentivized to further improve the risk-return profile of the investment, making this option attractive for all parties involved in the transaction.  In proof, green bond issuance peaked at $64.9 billion - a 21% increase over the second quarter of 2020 and the highest third quarter issuance on record - further underscoring the value perceived by the investment community in this market.  

The green bonds market has paved the way for other funding mechanisms for ESG-related projects, with the emergence of social bonds, available to support projects that positively impact community stakeholders. This is in addition to sustainability bonds, available to support a broader context of environmentally-beneficial projects as well as projects with blended ESG impact.

ESG in private debt – today and tomorrow

ESG integration in private debt has also been in place as a practice for a long period of time. Debt investors have historically considered certain ESG elements in core fundamentals, though not always referring to them as such. Currently, the majority of private debt investors implement ESG as a risk analysis prior to making an investment decision. As a pre-transaction screening activity, ESG factors can be weighted based on materiality and applied to the basic credit-worthiness of the underlying investment.  Pre-transaction screening may also be leveraged through implementation of an exclusionary policy, recognizing that an investment may have multiple entities which require screening to ensure that policy terms are indeed employed.  

Monitoring of ESG characteristics over the term of a private debt investment is developing as a practice.  With the proliferation of ESG integration across asset classes and markets, private debt managers have begun tracking ESG developments in investments over time, leveraging internal and external data approaches to do so. 

While this process is becoming more standard, taking action on monitoring data is far less prevalent. Most private debt investment managers lack the kinds of leverage that the bank-funded investments — discussed previously— may enjoy, such as tranches of funding, boilerplate ESG covenants, etc. As such, many debt investors recognize these challenges and see monitoring as one of the key areas of evolution for ESG integration.

Evolution of ESG strategies

Though not yet being widely executed today, strategies being discussed and tested by many in the space include:

• Additional reporting requirements – additional levels of reporting on given topics triggered by poor ESG performance in monitoring.
• Interest rate adjustments – incentives (rate discounts) and penalties (rate increases) tied to ESG performance.
• Other fee flexibility – relaxation of other fees or more flexible covenants tied to positive ESG performance.

While integration of ESG-related principles into the lending process isn’t necessarily a new concept, the market is evolving to make space for broader, more dynamic ESG-based investment opportunities. 

Present circumstances are facilitating a shift in the overall ESG conversation, allowing socially-focused topics, such as modern slavery practices, environmental justice, and diversity, equity and inclusion, to take center-stage alongside emerging disclosure requirements in the carbon and climate change space. 

Coupled with a strengthening self-directed desire of investors to prioritize ESG-based investment behaviors, the continued momentum driving impact investment will serve to not only create space for new and innovative investment opportunities, but to also support furthering improvement in tracking ESG-related performance for existing assets.  

Over the next 12-24 months, we expect to see additional uptake of these concepts and indeed further testing and integration of rate and other fee-aligned ESG covenants in debt agreements.

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