Pension schemes are increasingly active in considering how environmental, social and governance (ESG) matters are assessed and managed in their portfolios.
This includes investments in the private European loan market, an asset class that has become an important allocation for many UK local authority pension funds.
In Europe, leveraged loans occupy the space between liquid public bonds and illiquid private debt. Companies are typically unlisted and so less exposed to the expectations of the listed equity and debt worlds, which can raise challenges for investors.
However, this does not mean that lenders are without influence – particularly those that remain private-side. Lenders receive private information from issuers through the life of the investment, creating scope for both financial and non-financial disclosures to be made outside the regular reporting cycle. This can help to highlight any emerging ESG issues and identify remedial action to reduce risks and improve performance, where possible.
The role of private equity: shifting attitudes towards ESG
The European loan market is dominated by private equity-owned borrowers, and corporate dealmaking is the single biggest driver of the market.
Many believe the size of the private equity industry, and the characteristics of its business model (such as long ownership periods), give it a clear role to play in influencing companies in effectively managing ESG issues. This is particularly pertinent considering many private equity-owned companies will one day be publicly listed.
ESG integration is an evolving topic for the industry. Nearly all private equity houses (96%) surveyed by PwC for its Global Private Equity Responsible Investment Survey 2016 said they had, or would have, a responsible investment policy.
The survey also highlighted growing interest in integrating ESG management throughout the deal cycle – from screening targets to capturing value on exit.
Before acquiring a company, private equity firms look out for red flags: any potential or actual problems that have the potential to create additional costs, fines or reputational damage, according to PwC. After acquiring a company, the focus typically switches to reporting on progress as changes are made.
Disclosure and governance are key to responsible lending
Unlike asset owners and equity holders, debt providers typically have limited formal influence over companies. However, in our experience, the direct, private relationship between loan provider and borrower, and the contractual nature of the loan, create relatively frequent contact between the parties that permits typically greater engagement than in the bond market.
There has been considerable improvement in both the number of companies providing ESG data and the quality of information they provide. Having depth and breadth can allow a manager to assess how material ESG factors may be.
Before we decide to invest in a loan, we determine with the sponsor what ESG due diligence was performed prior to acquisition and whether any red flags were reported. Thereafter, we monitor the development and implementation of ESG policies and measures, and assess their resilience.
We use our frequent interaction with our portfolio companies and their owners during the life of our investment to attest to their governance models, environmental and social operating policies and guidelines and, where appropriate, lobby for greater disclosure of ESG issues. If an event occurs that is deemed to have material ESG significance, we demand full details, explanation and advice of remedial and preventative action.
When a company is sold to a new owner, that buyer’s structure, history and aspirations for the company become important considerations, as does its own attitude to ESG. We aim also to meet its key personnel as well as company management. One of the key benefits of being private-side is access to full due diligence of a company, so any past ESG issues, including rectification measures, must be disclosed to us.
Typical reasons to decline a transaction on ESG grounds include opaque ownership structures and/or governance. Since loans, like most fixed income investments, carry a risk of loss that is greater than the expected total return, any significant ESG uncertainty typically results in our declining to lend.
In our view, a poor approach to ESG is symptomatic of a more general unwillingness to embrace transparency.
Helping to develop ‘green’ lending standards
In March 2018, the Loan Market Association (LMA), the body that establishes guidelines for the EMEA syndicated loan market, published Green Loan Principles – the first step towards establishing widely accepted principles in green lending. As a member of the LMA’s Green Lending working party, we took an active role in drafting these principles.
M&G also participated in the United Nations Principles for Responsible Investment (Unpri) Bondholder Engagement Working Group, to develop guidance for bondholders on responsible investment practices. This recently published the report ESG engagement for fixed income investors: managing risks, enhancing returns.
Fiona Hagdrup, leveraged finance fund manager, M&G Investments
Column sponsored and supplied by M&G investments