Private credit makes inroad into sustainable finance amidst strong momentum for ESG standardization

Sustainable finance boom

There is no denying that sustainable finance is no longer a niche but is now a mainstream component of today’s global finance landscape. Since the launch of the first green bond in 2007, a lot has happened in terms of product (use-of-proceeds vs. KPI or performance-based) and thematic (green, social, sustainability, sustainability-linked) diversification. These innovations have not simply opened the doors for a broad swathe of issuers, including those from the so-called ‘brown industries’, they have also facilitated penetration into several financial products such as loans and derivatives, albeit mainly in public markets.

Sustainable finance in the public markets continues to see record growth in volumes thanks to significant investor appetite, enhanced regulatory scrutiny to foster transparency, and pressure from civil society. As of year-end 2021, sustainable bonds accounted for about 10% (~USD1.2 trillion) of worldwide bond issuance, a 20x surge from their 2015 levels. And on the lending side, where it made a late arrival, sustainable loans totaled ~$774 in 2021 alone, 400% higher than their levels in 2020. Based on estimates from the US syndicated loan market, ESG lending represented roughly 8% of the $2.9 trillion market activity in 2021.

Private credit steps into sustainable finance

When viewed against the development in the public debt market, the pace at which sustainable finance has permeated private credit is far from impressive. It was not until December 2019 that what is believed to be the first leveraged credit sustainability-themed transaction, a funded term loan B for Carlye’s acquisition of a minority stake in Jeanologia was announced. Almost a year later, private credit saw its first sustainable unitranche transaction, an ESG-linked facility from Barings to Eurazeo to support the buyout of UTAC CERAM. Only a handful of transactions have since followed, and it is difficult to estimate overall deal size [FE1]?because most transactions in this segment are not publicly disclosed.

Cross Section of Private ESG-Linked Debt (Source: Author based on desk research)

Among the reasons for the late engagement of private credit with sustainable finance is the unique nature of private borrowers; mostly private-equity backed small to mid-cap businesses who lack access to the capital market, as opposed to the listed companies making ESG headways.

These companies do not often have the resources to deal with the sophistication and reporting necessary for sustainable finance issuers to align with best market practice. Take environmental disclosures as an example, the Science-Based Target initiative (SBTi) estimates that roughly 0.03% of the 17 million private investable companies report to the CDP, while 10% of 41,000 public investable companies report to the CDP (NB: CDP disclosure is not a condition for issuing ICMA/LMA aligned sustainable instruments).

The companies who report on their sustainability performance and/or eventually launch into sustainable finance will also have to deal with the additional layer of cost and enhanced reporting.

Despite these challenges, there are several benefits when sustainability features are incorporated in private credit transactions. To begin with, private lenders will be supporting capital reallocation to businesses putting sustainability at the centre of what they do either through financing raised exclusively for environmentally and socially responsible projects or general-purpose debt with pricing hinged on performance on pre-defined sustainability targets. It will have an impact beyond regular sustainability due diligence and exclusion policies since it directly wires incentives into credit transactions.

Besides, private debt is now an important asset class, with nearly $1.2 trillion in assets under management, making it not so far from the institutional loan market.

Cognizant of this fact, it is interesting to see several private lenders now aligning deal structures with sustainability objectives, although differences in approach exist. While some like Carlyle focus on linking deals to margin-ratchets (step-ups and/or step-downs) based on sustainability performance indicators, others such as Capital Dynamics have voiced their preference for ‘express ESG covenants’ in loan documentation that may trigger a breach or an event of default. The latter approach could be a powerful tool to influence corporate behaviour. However, ESG covenants alone fall short of providing the direct margin incentives that companies can gain under the former.

Preserving market integrity is essential

Whichever path they follow, lenders need to pay attention to factors such as market integrity which are crucial as the space opens to sustainability. The choice of sustainability performance indicators for ESG-linked debt or ESG Covenants must be?material?and?relevant?to the borrower’s sector. It should be grounded in how the borrower can contribute to broader societal advancement in those areas by improving their operations. Some performance indicators will be transversal (e.g. Diversity, equity, and inclusion, GHG emissions), while others will be rather industry-specific (e.g. water use by pharmaceutical companies and other sectors where this is material).??

The level of?ambition?and?measurability?of the indicators are some other fundamental features lenders must consider for private credit to deliver on sustainability. What magnitude of impact will those targets have? By what standards do we determine the appropriate target levels? How will progress be assessed over time? Does the calibration of the margin ratchet adequately incentivize desired outcomes? These are some sustainable finance debates happening in public markets, and private markets will certainly need to address these questions as well.

Further, borrowers and lenders will have to demonstrate a commitment to transparency which is sacrosanct for an instrument designed to achieve tangible outcomes. Even though private credit is not subject to the same level of public disclosure expected in public markets, lenders and borrowers should adopt appropriate monitoring, reporting, and verification system. This is also useful in terms of aligning with the mandates of asset owners, the evolving nature of regulation, and the value of a good reputation.

In light of the above, recent advancements toward common ESG disclosure frameworks for portfolio companies and general partners are commendable. For instance, the work of various industry associations and partners like the UN PRI will help to streamline processes and avoid unnecessary overlaps. Another advantage of harmonization is that it will facilitate the benchmarking process for selecting sustainability KPIs and targets for ESG-linked credit facilities. In addition, a central data portal like the ESG Data Convergence project will make comparisons of peers across industries and regions less daunting and provide easy data access to both private equity and debt investors.

#esginvesting, #sustainablefinace #UNPRI #ESG #Sustainability #privatecredit #alternativeassets #alternativecredit

Disclaimer: The views expressed here are solely the author's and do not represent the position of their employer (past, current, and future).

?[FE1] A 2021 survey of 57 private credit managers and investors with about $600 billion AuM by the Alternative Credit Council notes that fewer than 10% have tied ESG performance to loans, 23% have been doing that not too frequently, while 28% had plans to do so in the succeeding year.