Influential investors

Expert takes on ESG in private markets

“Private credit investors may not have the control positions their equity cousins take, but they do have powerful tools to influence portfolio companies’ ESG outcomes”, says Reji Vettasseri, Lead Portfolio Manager for Private Markets at DECALIA

How important is ESG in private markets at a time when some investors have done well out of investments in areas such as oil and defence?

“It is true that people have had many things to worry about over the past year and that creates a risk that some lose focus on core values. Yet in private markets, ESG has actually become increasingly important. That’s partly because LPs expect this. The ultimate beneficiaries, such as pension plan savers, care much more than they used to. But industry professionals are also driving this. This last point is often under-estimated: there is a growing sense amongst investors that they should focus on ESG because it’s the right thing to do, not just because LPs asking for it."

“And for long-term investors there is not necessarily a trade-off with returns. Oil prices go up and down. Wars start and end. But for the foreseeable future there will be a pressing need to work on the big problems the world faces, and that also creates investment opportunity.”

So where is private credit on the ESG journey?

“In some ways, private credit is playing catch-up. A lot of the ideas and tools were developed in private equity, where investors usually take control positions."

“Many in private credit are now asking how they can do this. But there are tools in the private credit space that don’t exist in private equity, such as ESG margin ratchets and the inclusion of positive or negative covenants in loan documents that are tied to an ESG plan or that prevent borrowers doing harm."

“Almost all of our co-investments have some sort of ESG provision and we’ve found that these tools can be very powerful for private debt funds.”

Greenwashing is often a concern with ESG, but how much of an issue is this in private credit?

“We are now seeing a lot of people dressing up what they did before and putting a green label on it. I’ve seen fast casual restaurant chains labelled as somehow solving world hunger."

“If we want to improve this, we need a certain amount of data that is both sensible and honest. It needs to be a combination of things you can measure on a portfolio basis as well as metrics that are tailored and meaningful for the portfolio company. These company-specific metrics are where firms can really demonstrate good practice – it’s clear that the metrics for a chemicals producer are going to be very different from those for a software business."

“But data is not enough. In fact, excessive focus on data can be part of the problem because it can become a tick-box exercise. You really need people who genuinely believe in ESG and can tell a coherent and powerful story about what exactly they did on specific deals – you can only do this if you are actually doing something good.”

And where do you see room for improvement on the mechanics of ESG tools in private credit?

“ESG ratchets can work well, but very often the scale of increase or decrease is not significant enough. Firms put in a target that they know is going to be achieved and then set the increase or decrease at 10bps. That’s not going to make a lot of difference– it is just a signal of intent."

“For us, the most interesting managers work closely with borrowers to develop a specific ESG plan and use a combination of ‘soft power’ and covenants to ensure they are implemented. Genuinely converting a borrower to an ESG way of thinking is always the best; but to incentivise action, covenants create more issues if they are breached and so can be more powerful than ratchets.”