Don’t lose sight of ESG in distressed investing amid the COVID-19 pandemic

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Times of market stress and uncertainty can often provide unique investment opportunities. In today’s environment, there is no shortage of alternative investment managers raising billions of dollars for funds positioned as “Distressed Credit,” “Special Situations,” “Distressed-for-Control,” or “Opportunistic”.  These strategies aim to take advantage of dislocations in the market – today caused by the COVID-19 crisis – while offering attractive double-digit returns. On the surface, it may seem like a good idea to aggressively grow assets under management, but investors would be wise to ask themselves and their managers if today’s distressed lending strategies are aligned with the ESG philosophies that have been top of mind since well before the pandemic.

Taking unfair advantage of stressed businesses amid a volatile market not only goes against many ESG principles, but also may present the investor with undue headline or reputational risk in the coming months.

The pool of small- and middle-market companies that require financing in today’s market is large, and many potential borrowers who have spent decades building their businesses and livelihoods are now finding themselves in vulnerable positions as their hard-earned efforts melt away. Investors evaluating this private credit landscape need to consider the full ramifications beyond price below par of deploying capital into distressed loans. Opportunistic lending easily gives way to unforgiving lending practices, and no doubt some of these strategies will also live on the border of predatory lending. 

As many of these managers eagerly promote distress-for-control strategies, we must ask: Is it fair? Or are they taking advantage of borrowers who are struggling to survive in their current circumstances? The practice of making distressed loans to such borrowers with the intent to take control and radically change their business in an effort to capture the equity upside does not embody the type of governance or social responsibility that anyone in the general partner or limited partner community should feel good about. There is no virtue in charging painfully high interest rates to a suffering business owner in an arrangement that could very well be rife with conflicts. Taking unfair advantage of stressed businesses amid a volatile market not only goes against many ESG principles, but also may present the investor with undue headline or reputational risk in the coming months. 

There exists an appropriate balance between successfully lending in the current market and aligning to sustainable principles: by providing non-predatory loans to businesses without taking control and without making the investment’s end goal to earn outsized returns. Doing so means lending money for the benefit of – as opposed to at the expense of – businesses. Given the current interest rate and spread environment, a responsible lender can stabilise or even grow their business by making loans with appropriate risk-adjusted yields and no intention of charging usury rates by default.

Other worthwhile considerations in evaluating the lending practices of a manager include:

1.       What they are doing to offer extra attention and guidance to their existing portfolio companies, and;

2.      How they are augmenting internal risk and portfolio management resources effectively?

Given the unprecedented situation we are in today, one can argue that every loan is a special situation loan unto itself and offers lenders and business owners plenty of opportunity for prudent and long-lasting value creation.

Ultimately, the undesired outcome of all this would be a rise in asset managers focused on predatory lending for control to chase higher returns. This antiquated model is not in line with a paradigm shift in the investment landscape towards a more sustainable economy, nor does it represent the improved world many would like to build in the wake of this crisis. In that way, the current pandemic is challenging investors’ commitment and adherence to ESG, putting managers and investors at an important fork in the road as how to proceed in a post-COVID-19 investment world.

Andre Hakkak is the CEO of White Oak Global Advisors

Teresa Cutter is the Head of ESG & Impact at White Oak Global Advisors