This article is free, but to access more of our content, you can sign up for a no strings attached 28-day free trial here.
Private debt has rapidly grown from $300bn just a decade ago to $812bn today. Following the global financial crisis, banks curtailed lending to focus on strengthening balance sheets and meeting more stringent regulatory requirements. The corresponding withdrawal of banks fueled the rise of private credit. According to Preqin, the number of private credit managers doubled in five years to 1,764 in 2020.
Private credit’s emphasis on long-term credit quality lends well to incorporating ESG considerations to assess risk metrics and thematic issues including climate change, energy transition, resource availability, workforce practices and inclusive growth.
However, there is no standardised practice yet for environmental and social considerations when examining and underwriting private debt deals. The unique attributes of the diverse sub-asset classes that make up private credit require different approaches to ESG integration. As with private equity, ESG integration in private debt can happen throughout the investment lifecycle, from sourcing and diligence, through exit. Investors should identify potentially credit-relevant ESG issues that may occur over the life of the investment. Information for due diligence can come from a number of sources, including sell-side materials, legal and technical due diligence, private equity sponsor materials, and the lenders’ primary research (often in conjunction with subject matter experts).
We expect the share of private credit in the $170bn green and ESG-linked loans market to grow as private companies get better versed in understanding, disclosing and benchmarking ESG information
The limited availability of ESG data from private companies – especially lower middle-market ones – often makes the assessment of ESG data challenging. Private credit investors regularly partner with the sponsor or bank to gather pointed ESG information without overwhelming the borrower companies. The Sustainable Accounting Standards Board’s (SASB) industry-specific financial material criteria are increasingly being used by deal teams for guidance on material ESG information. Real estate or infrastructure debt investors often utilise GRESB assessments, which enable users to benchmark the ESG profile or performance of real assets and real asset funds on a global basis.
Educating and engaging with management teams on material ESG risks and opportunities is an effective approach increasingly taken by middle-market investors. During the holding period, investors monitor for ESG-related incidents and identify areas of growing ESG risk exposure. Very often, investors engage with private equity sponsors or banks for better ESG assessment and influence to bring about meaningful ESG improvements.
In order to substantiate the range of integration approaches, our team conducted interviews with executives at KKR and ZAIS Group.
Elizabeth Seeger, Managing Director of Sustainable Investing at KKR ($207bn AUM)
Elizabeth laid out a similar approach to ESG integration in credit compared to KKR’s other asset classes. In May 2020, the firm published its responsible investing policy. As with other assets, the credit side will incorporate ESG considerations during its due diligence process and will involve “meaningful” engagement over time. It appears KKR is highly aligned around SASB to prioritise material sustainability issues by industry. She acknowledged that access to good external data is challenging and the firm is in the process of piloting different tools to improve ESG analytics. At this time, KKR does not publicly disclose any ESG data for its private credit business.
Christian Zugel, CIO, ZAIS Group ($6.9bn AUM)
Christian shared that ZAIS Group rolled out a detailed ESG integration process earlier this year. The team is currently studying the many ways ESG analysis adds value beyond the obvious exclusions like fossil fuels. They are using Fitch criteria for securities like CMBS/RMBS and ABS. In corporate loans their ESG criteria are based on SASB materiality factors. ZAIS is also using the recommendations of the Taskforce on Climate-related Financial Disclosures to assess climate change-related risks at portfolio companies. Christian shared that the team is currently working on creating two new ESG opportunities: ii) a securitisation strategy akin to a CLO, where the loans would be extended to companies that are well-positioned to leverage the opportunities of climate transition, and ii) a small fixed-income fund in Europe with a 100% ESG focus.
ESG integration in private credit is a relatively recent phenomenon. However, as demonstrated by our conversations with practitioners, that has not stopped managers from either leveraging best practices of their private equity counterparts or developing unique integration mechanisms.
Despite a fundraising slowdown amid the COVID-19 pandemic, industry players continue to deploy different methodologies to ESG integration. We expect the share of private credit in the $170bn green and ESG-linked loans market to grow as private companies get better versed in understanding, disclosing and benchmarking ESG information. We foresee the trend extending to CLOs as well. Green CLOs are worth about €1.5bn, representing a small but growing slice of the €27bn European CLO market, according to S&P Global Market Intelligence.
Concurrently, we are noticing private market ESG data innovations including a slew of new launches in 2020. The development of data capabilities is likely to provide a boost to the practice by bringing greater measurability and credibility.
Sharadiya Dasgupta is Founding Partner at Blue Dot Capital.
Kuni Chen, CFA, is an independent ESG consultant.